When you need funds, you can choose from credit options like a personal loan or an overdraft. The choice between the two can be based on how long you need the money, how the interest is charged, how you will repay, etc. So, let us discuss what is a personal loan and an overdraft, the differences between them, and which one is better for you.
What is a personal loan?
A personal loan is an unsecured loan in which the bank lends you a specified amount at a specified interest rate for a specified period. You have to pay a specified EMI on a specified date every month. A personal loan doesn’t provide any flexibility for EMI repayment in terms of the amount to be paid and the date on which it can be paid.
If you foreclose the outstanding amount before the original tenure, the bank may charge you a penalty. Also, you have to pay interest on the entire principal amount, irrespective of whether you use the amount or not.
What is an overdraft?
An overdraft is a credit line provided by the bank for a specified limit for a specified tenure at a specified interest. You have the flexibility to withdraw the amount from the approved limit whenever you want. Also, you have the flexibility to repay the amount whenever you want. The interest is charged on the amount utilised and for the number of days utilised. There is no penalty on prepayment.
Differences between a personal loan and an overdraft
Now that we understand the basics of a personal loan and an overdraft, let us know their differences.
| Feature | Personal Loan | Overdraft |
| Loan amount | A fixed loan amount is paid to you in a lump sum. | A fixed limit is approved for you, and you can withdraw the amount as per need. |
| Interest calculation | In a personal loan, the interest amount is calculated on a monthly basis. | In an overdraft, the interest amount is calculated on a daily basis on the amount utilised and for the number of days utilised. |
| Repayment | The borrower has to pay a specified EMI every month on a specified date. The EMI repayment schedule is specified at the time of giving the loan. | The borrower has the flexibility to repay whenever they want. They just need to deposit the amount in the overdraft account. There is no fixed repayment schedule. |
| Loan tenure | A personal loan is usually more suited for medium-term tenure of two to five years. | An overdraft is usually more suited for a short-term tenure of up to a year. |
Personal loan or overdraft: Which one is better for you?
In the above section, we have discussed the differences between a personal loan and an overdraft. So, how do you decide whether a personal loan or an overdraft is better for you? Well, it depends on the situation. Let us discuss some scenarios and which one you should opt for in each scenario.
The loan amount is known in advance: A personal loan is suitable for an individual who knows exactly the amount they need and the tenure for which they need. For example, if you want to renovate your house wherein you have already obtained a quotation, you may go for a personal loan. Similarly, if you want to buy a mobile, laptop, or consumer durable and already know the price, you may go for a personal loan.
On the other hand, if you need funds but are not sure of the exact amount, you may go for an overdraft. For example, if there is a medical emergency, and you are not sure how much the hospitalisation and post-hospitalisation expenses are, you may go for an overdraft. In such a scenario, you can withdraw the amount as per requirement.
Monthly cash inflows and repayment capacity are known in advance: If you are a salaried individual with a fixed monthly cash inflow and know how much money you can pay as EMI, you may opt for a personal loan. On the other hand, for self-employed individuals, the monthly cash inflows are uneven. In such a scenario, they are not sure whether they can pay a specified EMI every month. Hence, they may opt for an overdraft.
Are you an impulsive spender?
Some people are compulsive spenders and end up buying things that they may or may not need. When they buy things they don’t need, on a high-cost loan, they pay high interest on it. If you are one such impulsive spender, you may go for a personal loan for a specified amount. In such a scenario, you will not be able to spend more than the personal loan amount that has been disbursed to you.
On the other hand, if you are a mindful spender who is prudent about need-based spending only, you may opt for an overdraft. With judicious use of borrowed money, you can avoid high-cost debt.
To conclude, choosing between a personal loan and an overdraft depends on the situation. Consider factors like whether you know the exact amount you need, your monthly cash inflows, the repayment capacity, whether you are an impulsive spender, etc. After evaluating these factors, you will have clarity on whether a personal loan or an overdraft is better for you.
Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.
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Published: 19 Feb 2024, 09:33 AM IST