Loans: Should you opt for an overdraft facility?

In an era of rising interest rates, borrowing wisely is essential. For emergency needs, most individuals turn to personal loans. However, an overdraft account at a bank can help meet any short-term financial needs and avoid liquidating other savings and investments.

A bank will allow an account holder to withdraw money beyond what is available in their bank account. The credit limit is set by the bank based on the balance of the account holder. The interest rate depends on the overdraft amount and the period.

Adhil Shetty, CEO of Bankbazaar.com, explains that an overdraft facility is usually tied to the borrower’s bank account, allowing the borrower to withdraw up to a set limit an amount in addition to the account balance. “It’s similar to revolving credit like credit cards where you can use credit up to a set limit, pay off your dues, and have your credit limit reinstated,” he says.

Personal loan or overdraft?
One of the biggest advantages of an overdraft facility is that interest will only be charged on the amount withdrawn compared to a personal loan where interest is charged from the day the amount is disbursed. To qualify for personal loans, the lender will perform background checks and verify documents each time the borrower applies for a loan. In case of overdraft, the documentation is done only once and the borrower can withdraw money several times from the same account up to the amount sanctioned for overdraft.

Loans offered as an overdraft facility allow borrowers to repeatedly withdraw any amount from the authorized limit, repay the amount withdrawn and borrow again, as needed. Interest is charged only on the drawn amount until it is repaid.

Sahil Arora, Senior Manager, Paisabazaar, said that although the interest component has to be handled monthly, borrowers have the flexibility to handle the principal component depending on the availability of their funds. “An overdraft facility is best suited for those who face frequent short-term cash mismatches. The higher repayment flexibility offered by overdraft facilities causes lenders to charge higher interest rates than personal loans loans offered in the form of a term loan,” he says.

What to pay attention to
Experts say that while availing overdraft facility is faster than personal loan, borrower should be careful. In the event of a pre-approved overdraft at a bank, the individual must keep an eye on the loan and repay regularly. Experts say unchecked borrowing can lead to a debt trap, as interest will continue to accrue.

Borrowers with sufficient repayment capacity to repay the borrowed lump sum within a very short period of time, such as less than three months, should opt for a personal loan overdraft facility, Arora says. He adds that others should stick with the regular personal loans offered as fixed term loans and EMIs. “Most lenders charge fixed interest rates on personal loans, whether term or short. So, once a borrower avails a personal loan, their interest rate would remain unchanged regardless of changes in the interest rate regime,” he says.

Borrowers should compare overdrafts by interest rate, processing fees, and renewal fees. “See how the fees compare to other forms of borrowing that meet similar needs. For employees, credit cards can be just as useful. For freelancers who need flexibility with their cash, an overdraft can be helpful. Interest only applies to the credit you have and prepayments are free,” says Shetty.

Overdraft rules
An overdraft facility is usually linked to the borrower’s bank account
Interest is only charged on the amount withdrawn from an account with overdraft facility
Borrowers can withdraw any amount from the sanctioned limit multiple times
Unchecked borrowing can lead to a debt trap as interest will continue to accrue
Compare overdrafts from different banks by interest rate, processing fees, and renewal fees before settling on one.

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