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Overdrafts vs. Payday Loans

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From time to time, it happens to all of us. There’s an unexpected emergency that requires us to spend money that we’re not likely to have just sat there waiting to be used. From car breakdowns to home repair jobs, if you need to urgently borrow a couple of hundred pounds or so to tide you over to the next payday, what’s best? Dipping into an overdraft or taking out a short-term loan?

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What types of overdraft are there?

An overdraft lets you use your bank’s current account to take out more money than what you actually have by letting you borrow money up to a certain amount. Some banks automatically offer this, but many require you to ask for an account with an accompanying overdraft feature.

Even if you’re sensible enough to have applied for an agreed overdraft already, it could be possible that you have maxed it out so you may need to ask the bank to agree to increase the limit on it if you want to use it to help you out with your emergency.

Remember though that there’s very likely to be pre-agreed fees or interest payable on your overdraft. Again, some lenders offer deals where if you only need a low limit overdraft you can get it fee or interest-free but even then, these tend to be for a limited period only.

Types of overdraft

The starting point then is to check if you’ve got an overdraft facility that you can use and, if not, contact the bank now to see if this can be made available. Because it’s created through mutual consent, this type of overdraft is known as an “agreed/authorised overdraft”.

If you take out more money from your account than what you know is available to you without agreeing it with the lender in advance, that’s what is known as an “unauthorised/unplanned overdraft” and it used to mean some exceptionally hefty daily fees and charges for borrowing from the lender without permission. However, since April 2020, banks are no longer allowed to do this. The interest payable on all overdrafts is now charged as a single annual interest rate (APR), making it much easier to compare different accounts and their charges.

By way of example, if you were to now dip into an overdraft with one of the main banks/building societies, of say £100 for 7 days, this would cost you anywhere from nothing in interest to 65p (source: https://www.fca.org.uk/data/changes-overdraft-charges), regardless as to whether the overdraft was agreed in advance or not.

Cost isn’t the only thing to consider though when weighing up whether an overdraft is the right option for you, so we’ve compiled a shortlist of the advantages and disadvantages.

What are the Pros and cons of an overdraft?

Pros:

  • Tend to offer more flexible borrowing and repayment choices in terms of how much to pay back each month.
  • Tend to be a cheaper shorter-term option than a loan, especially if you’re able to obtain one that doesn’t charge you interest.

Cons:

  • You may not be able to access a current account/overdraft facility.
  • Funds available via an overdraft are usually more limited than with a short-term loan.
  • Some people start to dip into their overdraft regularly for non-emergencies and so the fees become never-ending and more than originally anticipated.
  • Stricter application criteria means that if you have some bad credit, you may not be approved.
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What is a short-term loan?

A short-term loan is exactly that – a sum of money advanced to you which you agree to pay back within a short repayment period, usually within one to 12 months at a representative APR over 99.9%. These are often referred to as payday loans.

Short term loans do have a bad reputation as being costly but, like with many things, if you shop around and do your homework, some deals are better than others.

Sticking with the example of borrowing £100, as a minimum, you’re likely to need to take the short-term loan for at least 30 days. When the 30 days are up, you’ll have to ensure you’ve paid back the £100 as well as paying around £24 back in interest (source: https://www.stepchange.org/debt-info/payday-loan-calculator.aspx).

Whether it’s right for you though will depend on your personal circumstances. There may also be other benefits to consider when taking out a short-term loan that simply aren’t available with an overdraft.

What are the Pros and cons with a short-term loan?

Pros:

  • You can usually borrow more than you can with an overdraft.
  • Because the interest rates are usually fixed, you always know how much you’ll be paying throughout the lifetime of the loan from the start.
  • Generally higher acceptance rates than bank overdrafts

Cons:

  • The cost in terms of interest can be very high in comparison to an overdraft, especially since the rules changed in April 2020.
  • If you take out a loan secured over your property or some other high-value asset, then you risk losing your home (or other asset).
  • They are less flexible as the repayment frequency and amounts are pre-set by the lender, although you can, of course, contact them if you think you’re going to have difficulty making a payment as agreed. There’s no guarantee that they’ll change the agreement though.
  • There’s often a fee payable if you want to pay back the loan early.

Should you opt for a short-term loan or an overdraft?

Bearing in mind the changes that came into effect in April 2020 and our examples above, it’s clear that, especially for smaller amounts of money over shorter periods of just a month or two, an overdraft, especially one that has no fees or interest payable, is the better option.

Where you’re looking for larger funds of more than a couple of hundred pounds or so and a longer amount of time to repay the amount you’ve borrowed, then a short-term loan may be more beneficial as long as you make sure that you can definitely pay it back in the time and amounts agreed, even if your circumstances unexpectedly change. Short-term loans are also more beneficial for those who do not have access to a current account/overdraft facility.