Difference Between Overdraft and Loan

Common in the banking industry, the words overdraft and loan make one of the most confusing pairs of words. Notably, both of the words involve borrowing cash from a financial institution.

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However, the terms and conditions of borrowing some extra cash from a financial institution lead to differences between an overdraft and a loan.

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.

Overdraft vs Loan

Comparison Table

Parameter of ComparisonOverdraftLoan
PurposeFor 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 RequirementsRequires no security or collateral for acquisition.Requires security or collateral for acquisition.
RepaymentInterest rates are higher compared to loans.Interest rates are lower compared to overdrafts.
Time DurationOffered for a few days to six monthsIt is offered for a longer period. The duration can reach up to twenty years.
Process of AcquisitionNo 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 is entitled to withdraw excess money than their current bank account amount.

An overdraft can be viewed as a short term loan where a current bank account holder is entitled to during withdrawal if the need arises.

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.

Overdraft

What is a Loan?

On the other hand, a loan refers to borrowed capital that a financial institution lends to either an individual or an organization for some specific purpose, having the amount repaid over time.

Notably, 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.

Loan

Main Differences Between an Overdraft and a Loan

Purpose

A bank overdraft is a facility that extended to 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 payment 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 on assets for a business or individuals, setting up a business, or even systems upgrade.

Notably, loans cannot be obtained to cover payrolls, unlike overdrafts.

Security Requirements

While seeking a bank overdraft, no security or collateral is required to be availed by a current bank account holder. However, an individual or a bank must have a current bank account with the bank they are seeking 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 in which the loan is to be paid.

The individual or company already knows the amount expected to pay for every month from dividing the total payable amount by the stipulated duration of payment.

On the other side, overdrafts repayment are different from those of a loan. Repayment of an overdraft is made when the company or individual has the convenience of additional money.

Notably, the interest rates of an overdraft are higher than those of 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, where repayment is made between a few days to six months.

On the other side, loans have a time duration longer than that of 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 the fact that loan liability is huge and takes a longer period of repayment.

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.

Difference Between Overdraft and Loan

References

  1. https://www.econstor.eu/bitstream/10419/60770/1/622767518.pdf
  2. https://www.law.gmu.edu/assets/files/publications/working_papers/1366.pdf
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