How should borrowers decide between a term loan and availing an overdraft facility? MintGenie explains

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Initially, you can consider tapping into your savings. However, if your savings are insufficient or a considerable portion of your income is tied up in non-retrievable or long-term investments, your primary option may be to explore obtaining a loan. When contemplating securing funds from a bank, two primary choices typically emerge – term loans and overdrafts. Each option possesses distinctive characteristics and is suitable for varying needs and circumstances. Here’s a brief overview to assist you in making a decision:

Term loans

You obtain a one-time lump sum, such as for buying a car or a home, which you must reimburse through fixed monthly installments (EMIs) over a predetermined duration, usually spanning several years. Some lenders may demand collateral, like your house or car, while others assess your creditworthiness. The interest rate is typically fixed and tends to be lower than that of overdrafts, contingent on factors like the type of loan, amount, and credit score. The loan amount can vary, catering to specific needs or expenditures, ranging from smaller amounts to larger sums. These expenses might involve one-time financial outlays like home improvement, debt consolidation, or significant purchases.

Commencing a loan with higher EMIs can result in a lower overall interest payment. The lender has the flexibility to set the term of the loan anywhere from five to 20 years or even longer, with interest calculated monthly. By making larger initial payments, the principal amount decreases more rapidly, effectively shortening the loan duration. Since interest is computed based on the remaining principal balance, a shorter loan term translates to less time for interest to accumulate, ultimately leading to a reduced overall interest payment. A substantial portion of the initial payments primarily addresses the principal rather than interest, consequently diminishing the future principal balance on which interest is assessed, further contributing to a decrease in the total interest paid.

Overdraft

Contrary to the misconception that overdrafts resemble loans, the former is not technically a conventional loan. In this context, the lender provides a specific credit limit, which you can utilize based on your needs. Essentially, an overdraft facility permits you to exceed your available account balance up to a predetermined limit. It serves as a flexible credit option associated with your checking account, with interest payments applicable solely to the utilized amount and its duration. While an overdraft shares certain features with a loan, such as interest charges and a credit limit, it operates differently in terms of repayment flexibility and the accrual of interest.

How does a term loan differ from an overdraft?

Distinguishing itself from a term loan, an overdraft incurs interest solely on the withdrawn amount through the overdraft facility. In contrast, with a term loan, interest applies to the entire loan amount right from the moment you receive the funds, irrespective of their utilization. Usually, a fixed annual percentage rate (APR) is imposed on the outstanding balance each month, translating to monthly interest payments on the remaining loan amount until it is completely repaid.

In an overdraft scenario, interest is levied exclusively on the withdrawn amount and for the duration it is utilized. Usually, a daily interest rate is applied to the utilized sum. Consequently, interest charges are only accrued on the days when there is an overdraft balance, and specifically, on the borrowed amount during those days.

In contrast to loans that come with predetermined repayment periods, overdrafts lack a fixed duration. You have the flexibility to access and repay the borrowed amount within your approved limit as per your requirements. While some banks may mandate the periodic renewal of your overdraft facility, usually on an annual basis, this does not necessarily entail repaying the entire amount utilized.

Therefore, although you cannot maintain a continuous overdraft balance for an extended period as with a long-term loan, you do possess flexibility in overseeing your usage and repayment within the approved limit. This characteristic renders overdrafts suitable for addressing short-term cash flow gaps or unexpected expenses.

Furthermore, in certain instances, you are eligible for tax exemptions on interest paid for specific loan types, but no such tax deductions apply to overdraft repayments. In India, under Section 80C of the Income Tax Act, deductions can be claimed for the principal amount repaid and interest paid within specified limits for a home loan taken for one’s residence. Additionally, Section 80E of the Act permits deductions for the entire interest amount paid on an education loan taken for oneself, one’s spouse, children, or a legal ward for pursuing full-time studies, up to the graduate level.

Should you opt for a term loan or an overdraft facility?

Comparing a term loan to an overdraft is not always a straightforward apples-to-apples analysis. The choice between them hinges on your individual needs and circumstances, with both the amount and duration being pivotal factors, though not the sole ones.

When faced with the need for a substantial amount of money, opting for a term loan is generally a superior choice over an overdraft. Term loans offer the potential for much larger sums compared to overdrafts. For instance, obtaining a mortgage for hundreds of thousands or even millions of dollars to purchase a house is entirely feasible with a term loan, a possibility not available with an overdraft.

Additionally, term loans typically feature fixed interest rates, providing a clear understanding of the total interest payments throughout the loan’s lifespan. This predictability enhances financial planning and stability, in contrast to the variable interest rates associated with overdrafts.

Designed for extended repayment periods, often spanning from several years to decades, term loans enable the distribution of the repayment burden. This results in more manageable monthly payments, particularly advantageous for dealing with substantial sums. Extended repayment durations and fixed interest rates commonly lead to lower overall interest costs in term loans, especially when compared to overdrafts for significant amounts.

However, if your financial needs are not substantial and you require funds for a shorter duration, opting for an overdraft may present a more suitable option. In the end, the optimal decision hinges on your unique circumstances and requirements. Thoughtfully evaluate the amount required, your ability to repay, creditworthiness, and interest rates before making a choice between a term loan and pursuing an overdraft.

 

 

 

 

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Published: 05 Feb 2024, 08:55 AM IST

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