Common in the banking industry, the words overdraft and loan make one of the most confusing. Notably, both of the words involve borrowing cash from a financial institution.
However, the terms and conditions of borrowing some extra cash from a financial institution lead to differences between an overdraft and a loan.
Key Takeaways
- Overdrafts provide short-term access to borrowed funds through a bank account, while loans involve borrowing a fixed amount for a predetermined period.
- Interest rates for overdrafts can be higher than loans, making them costlier for long-term borrowing.
- Overdrafts offer flexible repayment with no fixed schedule, whereas loans have a structured repayment plan.
Overdraft vs Loan
An overdraft is a credit facility that allows you to withdraw more money from your account than you have deposited. At the same time, a loan is a sum of money you borrow from a lender with interest. An overdraft is associated with checking accounts and is intended for short-term use. In contrast, a loan is intended for long-term use, and the terms and interest rate are fixed.
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Comparison Table
| Parameter of Comparison | Overdraft | Loan |
|---|---|---|
| Purpose | For day-to-day business operations. For example, paying wages, paying debtors, and paying bills. | For the facilitation of long-term capital purchases. For example, asset purchases, setting up businesses, and system upgrades. |
| Security Requirements | Requires no security or collateral for acquisition. | Requires security or collateral for acquisition. |
| Repayment | Interest rates are higher compared to loans. | Interest rates are lower compared to overdrafts. |
| Time Duration | Offered for a few days to six months | It is offered for a more extended period. The duration can reach up to twenty years. |
| Process of Acquisition | No internal process is required. | An internal process is required. |
What is Overdraft?
A bank overdraft refers to some credit facility where a current bank account holder can withdraw excess money over their current bank account amount.
An overdraft can be viewed as a short-term loan to which a current bank account holder is entitled during withdrawal if needed.
The limit at which an overdraft can be made is agreed upon between the bank and the account holder. However, the bank has all the rights to alter the limit of your overdraft.
What is a Loan?
On the other hand, a loan refers to borrowed capital that a financial institution lends to an individual or an organization for some specific purpose, repaying the amount over time.
A bank loan is a long-term liability on a business balance sheet. On an individual level, a loan might be short-term or long-term based on the period of payment it is scheduled to take.
Main Differences Between an Overdraft and a Loan
Purpose
A bank overdraft is an extended facility for current bank account holders to finance their day-to-day business operations. Through a bank overdraft, individuals and businesses can cover emergency expenses, pay wages to workers, issue payments to late debtors, and bill payments.
On the other hand, a loan is offered to an individual or a business that needs loads of cash for a long-term specific purpose.
A loan is defined as borrowed capital to facilitate capital purchases. They include purchases of assets for a business or individuals, setting up a business, or even systems upgrades.
Notably, loans cannot be obtained to cover payrolls, unlike overdrafts.
Security Requirements
While seeking a bank overdraft, a current bank account holder must avail of no security or collateral. However, an individual or a bank must have a current bank account with the bank they seek an overdraft.
Unlike giving out an overdraft, a bank always requires security or collateral against the loan. Notably, companies can borrow loans from whichever bank or financial institution they knock at their doors.
This is regardless of having a current bank account with the bank or not.
Repayment
The repayment of a loan is made through regular monthly installments. The interest is calculated from the product of the principal amount, the interest rate, and the duration of the loan to be paid.
The individual or company already knows the amount expected to pay every month by dividing the total payable amount by the stipulated payment duration.
On the other side, overdraft repayment differs from a loan. An overdraft is repaid when the company or individual has the convenience of additional money.
Notably, an overdraft’s interest rates are higher than the loans.
Time Duration
Overdrafts are given to individuals and companies to settle day-to-day expenses. The overdraft facility is used for short-term borrowing, with repayment between a few days to six months.
On the other side, loans have a longer duration than that overdrafts. Loans might take up to twenty years to be repaid.
Process of Acquisition
To acquire a loan from a financial institution, an individual or company goes through an internal process that involves the recognition of the need. This follows that loan liability is huge and takes a longer repayment period.
On the other side, the acquisition of an overdraft requires no internal planning process. So long as an individual or company is entitled to an overdraft, they can make it so long as it exceeds not the limit.
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
