Difference Between Overdraft and Term Loan

Edited by Diffzy | Updated on: May 28, 2023

       

Difference Between Overdraft and Term Loan

Why read @ Diffzy

Our articles are well-researched

We make unbiased comparisons

Our content is free to access

We are a one-stop platform for finding differences and comparisons

We compare similar terms in both tabular forms as well as in points


Introduction

To ensure that every business succeeds, obtaining the funds they require at a reasonable cost is essential. Therefore, there is only one method suitable for some when it comes to financing. 

Each company has unique funding requirements and needs and may search for various financing solutions like overdrafts or term loans. The financial institutions that offer these loans have their requirements, funding levels, conditions, and terms. 

Thus, small and large firms seeking to borrow from lenders may opt for term or overdraft loans.

Overdraft vs Term Loan

The significant distinction between an Overdraft and a Term Loan is how they are used; an Overdraft is used to fund operating expenses, usually based on a short-term origin. The term loan is generally utilized on a long-term basis and is used for high-value purchases.

Difference Between Overdraft and Term loan in Tabular Form

BasisOverdraft LoanTerm Loan
MeaningThe term "term loan" refers to a loan in which a set sum of cash is lent for a specified time. The loan is returned with interest.The term "term loan" refers to the loan in which a set sum of cash is lent for a specified time. The loan is returned with interest.
Security or CollateralFor overdraft services, no collateral or security is needed.Term loans can be secured and unsecured.
ProcessThe overdraft facility is easy to access because it doesn't need a lot of paperwork, and the money is easily accessible. It's a single-time procedure.For the term loan, no documentation is needed, and disbursal is straightforward.
TimeThese are cash-flow instruments for the short term.These are long-term investments.
UsageTherefore, it's a credit facility ideal for meeting working capital requirements like bill payments and wages. They are also regarded as emergency cash.It is a loaned capital used to fund the expansion of businesses, such as purchasing equipment or construction equipment and the building and repayment of debts. It can also meet working capital needs, such as paying bills. These are thought of as planned money.
Rate of InterestIn this instance, the interest is charged on the amount borrowed, i.e., only the amount utilized, not the total amount.The interest will be charged to the whole amount borrowed, regardless of whether it is utilized until the loan amount is paid.
Interest CalculationIn the event, in the event of an overdraft, the rate of interest is fixed and does not change.In the case of a term loan rate of interest is calculated monthly.
Current Account HolderFor an overdraft loan, it's not necessary to maintain a current bank account.If you are taking out an unsecured term loan, it's essential to maintain a current bank account.
Repayment. In this scenario, payment is made via bank deposits.For loans, the repayment can be made by demand or in monthly instalments.

What is Overdraft?

Overdraft is a service the bank provides to allow the withdrawal of funds from the account even when the balance is at zero. The facility is provided if an arrangement is signed in conjunction with the banks by the client to establish a specific withdrawal amount with a reasonable interest.

An overdraft extends credit to the bank account after it is at zero. This permits the client to utilize the funds even though there is a zero account balance.

The amount withdrawn will be within the limits the institution sets for its account. The interest will be due on the removed amount and an overdraft charge.

Overdraft options are typically utilized to make gains in the short term and must be paid out in a short time. The interest rate for this option is on the higher side than other borrowing options.

The bank provides this service to make any payment to protect the customer from non-payment consequences. In return, the interest is calculated based on the amount produced.

The amount available through overdrafts is lower and is dependent on the bank and the state of the account. It is also a kind of loan in which the borrower has to pay interest on the loan.

Types of overdraft

The two kinds of overdrafts on bank accounts include authorized and unauthorized.

Authorized bank overdraft

If an overdraft is approved, the arrangement is in place well ahead of time with the person who owns the account and the bank. The parties agree to an amount of borrowing that can be utilized with all standard payment methods. Naturally, this agreement includes a service charge that differs from bank to bank.

Typically, the fee is charged daily, weekly, or even monthly and is accompanied by interest ranging from 15 20 to 20% annual percentage rate. The sometimes high costs associated with an overdraft could be quite costly, particularly if the borrowing amount is not very large. Account-holders must be extremely cautious to stay clear of overdrafts, even if they are authorized.

Unauthorized bank overdraft

According to the definition, the amount was not negotiated beforehand, and the account holder has incurred more than his account's balance. Unauthorized overdrafts may also occur even when there is an earlier agreement if the account holder's spending has gone beyond the amount of the overdraft agreed upon.

Overdrafts not authorized by a bank account are charged more, making them more costly.

What is Term Loan?

The term loan is a type of financial arrangement made by the bank for the client and is paid back in regular time frames. The term loan can be described as a financial loan provided by a bank, which is typically between one and ten years.

There are specific term loans that could last for up as long as 35 years. These loans are available to individuals and small-sized businesses.

Term loans are generally used to finance high-value purchases. The interest rate isn't as high as an overdraft but is locked.

The regular instalments are to be paid monthly as an instalment, including the interest and your principal payment.

Finance experts recommend verifying whether the interest rate will be fixed or floating since the interest rate could affect future payments if rates fluctuate.

Another thing to consider when taking out a term loan is the kind of interest. It is recommended to find out whether the claim is compounding.

If yes, then the amount paid will increase over time. Getting term loans only for a brief period and not over a long period is also recommended. The market's insecurities could cause damage to the bank system as well as the economy.

Types of term loans

Once you've figured out the definition of a term loan, you need to know the different types of term loans to make an informed decision for your business. The term loans are classified created on the loan's drift, i.e., the extent of time you'll require the assets for. Thus, the kinds of term loans include Short-term, Medium-term, and long-term.

Short Term Loans

A short-term loan typically lasts lasting between 1 and two years. A short-term loan usually covers daily business requirements or the company's capital needs. There are various sources for short-term loans, such as loans from a commercial banking institution, Trade Credit, Discounting Bills of Exchange, Factoring, and many more.

A short-term loan is a higher cost of interest when compared to longer-term loans. Additionally, it could require some weekly payment if the term that the loan has is concise; as a rule, the shorter the duration and the more simple the loan can be obtained and paid off, the greater the interest rate. It is vital to be cautious when opting for this type of loan because it does not just come with an increased interest rate. However, charges could be higher when you fail to pay your repayments.

Medium-Term Loans

A medium-term loan typically lasts for 2-5 years. It could be described as an amalgamation of short- and long-term loans. The loan is usually used to fund repairs or renovation to your fixed assets. For instance, it could be used to modernize an exhibition.

The term "medium-term" loan is often avoided when discussing kinds of loans that are based on terms as individuals may choose to jump straight to the longer-term loan following discussion of loans for short durations.

 It is, however, more beneficial to keep the length between 2 and 5 years as the conditions and terms for this type of loan are slightly different from the long-term loan. For instance, the interest rate is higher in comparison, and the paperwork is less complicated than longer-term loans.

Long Term Loans

These kinds of term loans last longer than five years. The majority of these loans are secured. Such as mortgages and car loans, and loans secured by the property. Because it is confirmed, the interest rate is less. However, it could be connected as well. An unsecured loan is not required to secure collateral or assets. It is required.

However, the interest rate is generally higher because the lender takes on more risk. The EMI of a loan is also low since the loan is spread out over a lengthy time. A long-term loan is based on credit, and the higher the rating, the higher the chances of getting the lowest interest rate. Its amount will be contingent on your credit score and your income.

Additionally, a loan with a longer-term can also be flexible regarding the payment options. You could choose a fixed interest loan, where the interest rate remains the same throughout the loan, and an adjustable rate, in which the rate can change every year. There is also an interest-only loan, in which the borrower is only required to pay an interest rate for a predetermined time frame and then pay the principal.

SPECIAL COMMITMENT TERM LOAN

It provides a one-time, short-term loan with no more than a year of payment plan. It is regarded as interim financial support from the banks to purchase goods or cover or recuperate from urgent needs or crises. The loan is based on the relationships between the client and banks and may not be available in all aspects.

Main Differences Between Overdraft and Term Loans in Points

  • The options that banks offer to deal with cash crunch circumstances are admirable. It is essential to understand the difference to pick the most appropriate option. The significant difference between Overdraft and Term loans is their use. Overdraft is typically used in the short term to cover minor cash demands. A term loan is intended for longer-term use and can be used to purchase items of high value.
  • The amount provided by the bank in each case is different, and the overdraft will help the customer by offering a lesser amount of money, while term loans are enormous in total.
  • Banks' interest rate on overdrafts is always higher than the loan term.
  • The time to repay overdraft amounts is less compared with term loans. The term loan's duration can extend to up to 35 years.
  • Overdraft doesn't require an additional account to be opened typically, and term loans require an invoice for loans to be extended where the repayments will be recorded. The bank will automatically set up a loan account after repaying the loan.

Conclusion

The use of money for a good reason is always a good thing. The effects of loans and overdrafts can create problems for a person's mental health. Money management is crucial to maintaining a healthy future.

The banks offer beautiful facilities for their customers.

The customer must decide what is needed and what is not. Therefore, it's evident that an overdraft will not promise more money, but it can help with unexpected expenses. These loans are investment opportunities if they are channelled correctly.

The bank's support will be in effect for a lifetime if the debts are paid on time, without reminders. If the debt was not paid in time, additional charges and an impact on credit scores could occur.

Reference

  • https://www.wishfin.com/business-loan/term-loan-vs-overdraft-facility/
  • https://www.goodreturns.in/classroom/2015/08/5-differences-between-loan-overdraft-378406.html

Category


Cite this article

Use the citation below to add this article to your bibliography:


Styles:

×

MLA Style Citation


"Difference Between Overdraft and Term Loan." Diffzy.com, 2024. Thu. 29 Feb. 2024. <https://www.diffzy.com/article/difference-between-overdraft-and-term-loan-1226>.



Edited by
Diffzy


Share this article