Should you go for a personal loan or an overdraft facility?

When you get yourself an overdraft facility, what this means is that the bank (or lender) will extend a credit line to you at a pre-specified interest rate.

If you are in need of funds and don’t have any savings that you can dip into, then your only option is to borrow. And no, I am not referring to borrowing from family / friends, as that can be complicated.

The toss up is  between taking a personal loan or getting yourself an overdraft (OD) facility. What are these and which suits you better? Let’s try to understand.

Personal loans

Personal loans need no introduction. It is simply an unsecured loan that you can get from a bank. The loan tenure and interest rate are fixed. So, you know your equated monthly instalments (EMIs) in advance.

For example, if you take a personal loan of Rs 5 lakh at 12 percent for 3 years, then your monthly EMI will be Rs 17,510. You can try out MC’s personal loan EMI calculator here.

Overdraft facility

An overdraft is also about borrowing, but in a different manner. When you get yourself an overdraft facility, what this means is that the bank (or lender) will extend a credit line to you at a specified interest rate. But unlike personal loans, where you get the full loan amount upfront, in overdraft, you can choose to withdraw as much as you want within the approved limit.

So, if you have an overdraft facility of Rs 5 lakh from your bank, you have the flexibility to withdraw any amount — Rs 1 lakh, Rs 3 lakh, or even Rs 10,000 — whenever you want, as long as the total amount is within the overall approved limit.

What is the difference between a personal loan and an overdraft?

Now that we know how personal loans and overdrafts differ, let’s see what other distinctions one needs to know about:

• In a personal loan, the interest is calculated on a monthly basis on the full loan amount. Hence, if you take a Rs 5 lakh loan, then the interest is calculated on the full amount. In an overdraft, the interest is calculated only on the amount withdrawn (not the overdraft limit), and for the number of days the overdraft is utilised, before the money is repaid. But if you don’t withdraw any funds from the overdraft facility, then no interest will be charged at all.
• Generally, an overdraft facility usually has a higher rate of interest compared to a personal loan. But if it’s a secured overdraft (like an overdraft against a fixed deposit, and so on), then the rates are much lower.
• Unlike personal loans that have a predetermined tenure, an overdraft facility doesn’t have a fixed duration. You can continue to withdraw and repay monies within approved the limit as long as your overdraft facility is renewed by the bank.
• In personal loans, the repayment is structured via fixed EMIs calculated upfront. But in an overdraft facility, the repayment is flexible and one can repay any amount one wants. The only thing to note is that interest is calculated daily on the total outstanding that the overdraft facility has each day.

Personal loan or overdraft: which is better?

The answer will vary based on an individual’s requirements, like how much money is required, how much is available via personal loan vs overdraft, type of requirement (lump sum or staggered), interest rate, ability to service  EMIs vs ad-hoc large payments, etc.

But in general, OD facilities are known for flexibility and faster access to required funds, albeit at higher interest rates (for unsecured ODs). Also, ODs are better suited for a shorter duration, where you need funds for temporary liquidity crunches or for working capital requirements. A personal loan is more suited for longer durations and is more structured, and enforces disciplined repayment per a fixed schedule.

That said, both personal loans and OD facilities should be used with caution. Both are forms of borrowing and hence, it goes without saying that one should borrow only for genuine needs. Do not borrow for your discretionary expenses even though you may be tempted to do so every once in a while.