Loans or overdrafts - what’s better?

• What is a loan?
• When is a loan useful?
• What is an overdraft?
• When is an overdraft useful?
• How do I know if a loan or overdraft is right for me?
• Loans VS overdrafts - what’s better

While loans and overdrafts are both forms of debt, how they work and their uses are very different. Loans are suited for borrowing bigger sums of money which are paid over a longer period and require long-term planning. While overdrafts are suited for short-term money needs, they provide a small amount to see you through to your next payday.

But there is more to know when it comes to loans and overdrafts.

What is a loan?

A loan is a fixed amount borrowed and paid over an agreed period. Most people borrow from a financial institution or lender and pay interest on the amount borrowed. There are different types of loans in the UK, such as personal loans, mortgages and car loans - more on that next.

When is a loan useful?

Loans are suitable for larger purchases - for example, a kitchen refurb or a car purchase. They may be a good choice if you prefer structured, set payment amounts and have a clear plan to repay what you borrow.

The type of loan you choose will largely depend on your needs. Loan types include:

• Personal loans - are used for individual needs and are normally unsecured. Personal loans can range from £1,000 to £25,000 or more and are typically paid back between one year to five years.
• Car loans - are similar to personal loans, except they are specifically used to buy cars. One thing to remember is that a UK car loan can be secured against the vehicle purchased. There are other types of car finance, such as hire purchase and personal contract. 
• Mortgages - are loans to purchase a property. Usually, a deposit is required, and the loan is secured against the property. Mortgages are repaid over long periods (normally 25 years) and secured, so lenders can take your property if you fail to repay the loan.
• Short term loans - suited for smaller amounts, normally up to £1,000 and for short periods, from a month to twelve months. Short term loans (which can include payday loans) usually come with higher interest rates and should be used only for one-off emergencies - much like bank overdrafts.

What is an overdraft?

An overdraft is short-term borrowing through your current account. An overdraft occurs when more money is spent or withdrawn from a bank account than is available, causing a bank balance to be below zero. Interest charges apply when you go overdrawn.  

Not all bank accounts come with overdrafts. Your bank will normally pre-agree a limit on the amount you can borrow - called arranged overdrafts (or authorised overdrafts). An unarranged overdraft happens when your bank allows you to exceed your pre-agreed limit. 

Although fees and charges are the same for arranged and unarranged overdrafts, your bank is not obliged to provide you with an unarranged overdraft. And they may not allow a transaction to proceed if it will cause you to exceed your agreed limit.

When is an overdraft useful?

Overdrafts can be beneficial to avoid declined transactions or late payment fees. They are suited for those occasional moments when you are temporarily short on money before payday - it's a bit like a short-term loan provided by your bank.

The cost of an overdraft varies and depends on the bank. Most larger UK banks charge between 35% to 40% interest (including HSBC, Barclays and Nationwide). It's worth mentioning some banks offer an interest-free "buffer". For example, HSBC offers a £25 overdraft buffer with no interest charges, and Barclays offers a £15 buffer (some accounts are excluded). 

Although overdraft interest rates are capped at 40%, they are more expensive than a personal loan (except high-cost short term loans like payday loans). So, overdraft fees are not something you want to be paying often.

In a recent survey by MustCompare, we were surprised to see how many people use an overdraft every month - nearly 1 in 5 UK adults. Apart from the costs, the danger of always going overdrawn is your bank may view this as a sign of financial difficulties and remove overdraft services from your account. 

How do I know if a loan or overdraft is right for me?

Being very clear on why you need the credit and for what will help you with your decision. Also, knowing what you can afford to pay monthly and how long will enable you to decide whether the credit will suit your budget. It's also worth looking at the details and comparing the pros and cons before taking on a UK loan or requesting an overdraft. 

We've listed a few factors you may want to consider below.

Loans VS overdrafts - what’s better

Approval processes

• Applying for a loan is not straightforward; lenders will want to perform checks to ensure the loan is affordable and realistic for your circumstances and there are no risks of not getting paid back. This may be a problem if you are looking for an urgent solution. Checks will include looking at your earnings, expenses, current debt and credit checks, a bad credit score may impact your application.
• Getting an overdraft can be done through your bank. Normally, your bank will have all the information they need to hand, so a decision can be made quickly. If you have a basic account (which does not come with an overdraft), it will likely change to a current account. Again, your bank can do that once you're approved. If needed, your overdraft will kick in automatically. There is no need to repeatedly apply for credit.

Repayments

• Loan repayments are structured with a clear schedule, and the monthly amount is fixed - this may be better suited to persons with a set budget. However, this also means loan terms are not flexible, and early repayments may incur penalties.
• Overdraft repayments are dependent on what you borrow. Not paying your overdraft, normally at the end of the day, may mean you'll be charged up to 40% interest (depending on your bank). Staying overdrawn for an extended time will make you more likely to head into an unarranged overdraft.
  

Interest rates

• Loan interest rates in the UK average 10.15% as of May 2023 for a £5,000 personal loan (according to finder.com); the rate does decrease over longer periods. However, while interest rates may be lower than an overdraft, the total interest paid over the life of the loan will add up to a fair amount. So, it is worth looking at the total you will pay back when comparing loans.
• Overdraft rates are capped at 40% by law. As mentioned before, most larger banks charge between 35% and 40%. Of the bigger UK banks, the lowest rate we could find was the Starling Bank Current Account at 15% (or 25% or 35%, depending on your credit score). Overdraft interest rates are higher than loans (except for short term loans with high interest rates). Still, the amount to pay back may be relatively small if paid back quickly.

Borrowed amounts

• Loan amounts vary; these can be from a few hundred to a few thousand, and you can decide what you would like to borrow, subject to approval. However, there is always a danger of being tempted to ask for more than what you need.
• Overdraft amounts are limited to the amount you go overdrawn and the amount approved by your bank - normally a few hundred pounds. While it may be beneficial that you can only borrow what you need, there is the danger of becoming overly dependent on your overdraft.

Credit scores

• A loan can improve your credit score if you pay it off on time. It will show lenders that you are reliable. However, missing a payment will negatively impact your credit score. 
• Overdrafts will be visible in your credit report. The balance will be zero if you don't use your arranged overdraft. However, these will appear on your credit report if you have used an unarranged overdraft or incurred charges. 

In summary

Although loans and overdrafts are forms of credit, they work differently. Deciding on what is right for you will depend on your financial needs and goals.

Loans are better suited if you require a large sum of money and plan to make a big purchase. Repayments may take years, and it's important you are confident what you have to pay back is realistic for your circumstances. While interest rates are cheaper, the total you pay back will be substantial over the long term.

Overdrafts, however, are a more flexible, short-term solution to cover minor expenses and take you to your next payday, a bit like pay-as-you-go credit. However, there is a danger of relying too heavily on overdrafts; they can be expensive, and your bank may remove this service if they think you are struggling financially.

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