Loan vs. Overdraft: A Comparative Guide

29^th Nov 2024...

Published By : Team 811

Choosing between a loan and an overdraft can be tricky. Both options offer different benefits and can be used for various financial needs like managing your budget, handling sudden expenses, or funding a project.

This blog will help you understand the key differences between loans and overdrafts so you can make a choice that fits your financial situation best.

What is a Personal Loan?

A personal loan is a sum of money borrowed from a financial institution that you pay back in fixed monthly instalments over a set period. It is usually unsecured, which means that it doesn’t require collateral like your home or plot.

Some of the most common benefits of taking a personal loan are as follows:

Fixed interest rates: Personal Loan Interest Rates are usually fixed, which means your repayment amount doesn't change throughout the loan's term.

Loan tenure: Loan terms can range from one to five years, depending on the lender’s policy and the loan amount.

Usage flexibility: Personal loans can be used for a variety of purposes, from home renovation to wedding funding.

Personal Loan Eligibility Criteria

Before applying for a personal loan, it’s important to understand the eligibility requirements, which include your credit score, income level, and employment status.

CIBIL score requirement: A CIBIL score over 750 is generally required to qualify for competitive interest rates.

Income stability: Lenders look for a stable income to ensure that they can meet their monthly repayment obligations.

Employment type: Being a salaried employee in a reputed company may improve the chances of approval.

What is an Overdraft?

An overdraft allows you to withdraw money from your bank account, even if the account balance is nill. It’s a type of extension of credit from your bank. Some of the most common reasons for opting for an overdraft are:

Flexibility: Overdrafts are flexible, allowing you to borrow as much as you need up to the limit approved by the bank.

Interest charges: You are charged interest only on the amount overdrawn, not on the total overdraft limit.

Quick access: Overdraft facilities can be set up very quickly, often with your existing bank.

Comparing Overdraft vs Personal Loan

When deciding between an overdraft vs personal loan, it's important to consider various factors that match your financial needs and circumstances. Overdrafts and personal loans serve different financial purposes and come with distinct terms and conditions.

As mentioned below, knowing about these can help you choose the right option for managing your finances efficiently.

Interest rates & fees: Overdrafts may have higher interest rates compared to personal loans, especially if the amount borrowed is large.

Repayment flexibility: Overdrafts offer more repayment flexibility compared to personal loans, which have a fixed repayment schedule.

Purpose of financing: Overdrafts are suitable for short-term liquidity or emergency funds, whereas personal loans are better for larger, planned expenses.

Impact on credit score: Regular use of an overdraft can affect your credit score negatively if the account frequently remains overdrawn. On the other hand, a personal loan, with consistent repayment, can help build your credit score.

Ease of access: Overdrafts can often be accessed immediately via your existing bank account, providing an easy solution for urgent financial needs without further credit applications. Personal loans, however, require a new application and are subject to approval processes, which can take time.

Also Read: Personal Loans For Non-Urgent Expenses: When To Use Them Wisely

Personal Loan Fees & Charges

Being aware of all the charges associated with personal loans can help you manage your finances more effectively. This usually includes:

Processing fee: Most lenders charge a processing fee, which can either be a flat rate or a percentage of the loan amount.

Late payment penalties: Late payments can incur high penalties, which could add to the loan cost.

Prepayment charges: Some lenders charge a fee if you repay your loan early.

How to use a Personal Loan EMI calculator?

A Personal Loan EMI Calculator is a handy tool for calculating the monthly payments required for your loan based on the principal, interest rate, and loan term. It also helps you assess how the loan will fit into your monthly budget and provides clarity on the financial commitment you’re about to make.

The EMI Calculator also allows you to input varying interest rates and loan terms from different lenders to see which loan offer is most affordable for you. Additionally, it helps you understand how increasing your down payment can put a toll on your monthly EMI and reduce the total interest paid over the life of the loan.

Essential Documents for Personal Loan Applications

To apply for a personal loan, you will need to provide several key documents that verify your identity, income, and creditworthiness, such as KYC documents such as your PAN card and Aadhaar card, income proof like salary slips or income tax returns, and employment proof such as an employment certificate or job offer letter.

Depending on the lender, you may also need to provide bank statements for the last six months, residential proof like a utility bill or rental agreement, and any other financial documents that support your application.

The document verification process is important as it helps lenders check your financial health and repayment capacity. It involves checking the validity and authenticity of the documents you submit, ensuring that all information is accurate, current and reflects your financial stability.

Also Read: Repo Rates & Reverse Repo Rates: Everything You Need To Know

Conclusion

Deciding between an overdraft vs personal loan depends largely on your financial situation and the purpose of the funding. Overdrafts are ideal for short-term financial needs or emergencies, providing flexibility and ease of use. On the other hand, personal loans are better suited for larger expenses requiring longer repayment periods.

By understanding each option’s features, costs, and eligibility criteria, you can choose to enhance your financial stability and meet your specific needs.

FAQs

1. How is interest calculated on a personal loan?

Interest on personal loans is calculated using the reducing balance method. This means that the interest decreases as you pay down the loan principal.

2. Can I prepay my personal loan without any charges?

Some lenders allow prepayment without charges, while others may add a prepayment penalty. Check your loan agreement for specific terms.

3. Can I increase my loan amount after approval?

Increasing your loan amount after approval is not usually possible; you would need to apply for a new loan or a top-up on your existing loan.

4. Are there any tax benefits on personal loans?

Generally, personal loans do not offer tax benefits. However, if the loan is used for specific purposes like home renovation or education, you might be eligible for tax deductions on the interest paid.

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This Article is for information purposes only. The views expressed in this Article do not necessarily constitute the views of Kotak Mahindra Bank Ltd. (“Bank”) or its employees. Bank makes no warranty of any kind with respect to the completeness or accuracy of the material and articles contained in this Newsletter. The information contained in this Article is sourced from empanelled external experts for the benefit of the customers and it does not constitute legal advice from Kotak. Kotak, its directors, employees, and contributors shall not be responsible or liable for any damage or loss resulting from or arising due to reliance on or use of any information contained herein.