Life can be quite unpredictable, and when you least expect it, a sudden medical emergency or an unforeseen natural calamity could throw you a curveball and lead to steep financial liabilities. If you have an emergency fund, you may find it easier to tackle such unexpected costs. But occasionally, the liabilities that crop up may be too much for your contingency fund too. Fortunately, during such a financial crisis, you can always rely on the credit facilities available today.

Of the many credit facilities you can avail, two of the most popular options are loans and overdrafts. A common misconception is that these two types of credit mean the same thing. In truth, they’re quite different. And the key to figuring out which credit facility is better for you lies in understanding what they each entail.

What is a loan?

A loan is a fixed amount of money that you can borrow from a bank or a financial institution. You need to repay the loan in equated monthly installments (EMIs) to the lending entity, over the course of a specified repayment tenure. The lender charges interest on the principal amount borrowed, and each EMI includes an interest component as well as a principal component.

The rate of interest is typically fixed at the time of borrowing. However, in the case of some loans, like flexi home loans, the rate of interest is tied to a benchmark like the repo rate. Loans can also be of two types —

  • Secured loans, which require a collateral
  • Unsecured loans, which do not require any collateral

You can borrow different types of loans from banks and financial institutions, such as personal loans, home loans and car or two-wheeler loans.

What is an overdraft?

An overdraft is a short-term credit facility offered to individuals and companies with a current account. Here, the account holder can withdraw cash in excess of the balance remaining in the current account, up to a certain predetermined credit limit. The bank will levy an interest charge on the overdraft amount (i.e. the excess amount withdrawn).

Overdrafts are generally secured by fixed deposits that the account holder has with the bank or the financial institution. The credit limit on the amount you can borrow via the overdraft facility is typically fixed as a percentage of the amount in the FD.

The key differences between a loan and an overdraft

We’ve covered what a loan and an overdraft mean. But when you dig a little deeper, there are more differences to unearth. Here is an overview of how a loan and an overdraft differ from one another.

Nature of credit:

Loans are, in essence, borrowed funds. Overdrafts, on the other hand, are simply withdrawals made from your current account. However, the withdrawal is in excess of the balance lying in your account.

Time horizon:

Loans are typically better suited for the long term. The repayment tenure can range from 5 years to 20 years or more. On the other hand, the overdraft option is a short-term credit facility, and is ideal if you have short-term fund requirements.

Interest calculation:

When you avail of a loan from a bank or a financial institution, the interest is calculated on a monthly basis. However, for an overdraft, the interest calculator is typically done on a daily basis.

Repayment method:

If you borrow funds by availing of a loan, you will be expected to repay it via equated monthly installments or EMIs. An overdraft, on the other hand, is repaid by simply depositing funds into your bank account.

Fund disbursal:

The process of disbursing funds is typically longer in the case of a loan. Although the time taken for this has shortened considerably in recent years, the lender still needs to verify your application and approve it. But in the case of overdraft facilities, you can typically get access to the funds needed in a few hours.

Tax benefits:

Some loans, like home loans and education loans, offer tax benefits on the repayments you make during the year. But overdraft facilities do not offer any tax saving advantages.

Summing up the differences between a loan and an overdraft

Here’s a preview of the differences between a loan and an overdraft at a glance.

Particulars

Loan

Overdraft

Meaning

Borrowed funds

Withdrawn cash

Nature of borrowal

Long-term

Short-term

Interest

Charged on a monthly basis

Charged on a daily basis

Repayment

Via EMIs

Via bank account deposits

Need to have a bank account with the lender

No

Yes

Tax benefits

Offered by some loans

No tax benefits

Loan vs. overdraft: Which is the better choice?

Well, that depends on why you need the funds and what your employment status is. If you are an individual with a good credit score, and if you need the funds for any specific purpose like buying a house or a car, there are specific loans that you can avail for these goals. An unsecured loan like a personal loan could also be useful if you are in need of emergency funds.

However, if you are a sole proprietor or a businessperson with a current account, an overdraft may be a more appropriate credit facility for short-term fund requirements. It can help you manage the day-to-day needs of your business better.

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Disclaimer: This Article is for information purpose only. The views expressed in this Article do not necessarily constitute the views of Kotak Mahindra Bank Ltd. (“Bank”) or its employees. Bank make no warranty of any kind with respect to the completeness or accuracy of the material and articles contained in this Newsletter. The information contained in this Article is sourced from empaneled external experts for the benefit of the customers and it does not constitute legal advice from Kotak. Kotak, its directors, employees and the contributors shall not be responsible or liable for any damage or loss resulting from or arising due to reliance on or use of any information contained herein.