Term Loan vs Overdraft Facility: The development of the banking system as well as its penetration has led to financial institutions designing a plethora of credit products customised to the needs of the consumers. The credit requirements of a retail shop owner are after all quite different from an exporter, or a logistics company.
An Overdraft Facility and a Term Loan are two such products that are offered by Financial Institutions but have a different purpose, usage, advantages and disadvantages.
Differences Between Term Loan and Overdraft Facility
| Basis | Term Loan | Overdraft Facility |
| Meaning | A loan is provided for a fixed tenure that must be repaid as per the schedule. | A line of credit is sanctioned to the borrower from which they could borrow as and when needed. |
| Purpose | Usually taken for business expansion, investment, etc. | Usually taken for working capital requirements. |
| Charges | There may be charges if the loan is prepaid. | No charges if the amount borrowed is prepaid. |
| Time Period | The tenure is usually long-term (more than a year) | The tenure is short-term (less than a year), except in the case of Drop-line Overdrafts (DODs). |
| Renewal | It does not have to be renewed each year. | It must be renewed each year, except in the case of Drop-line Overdrafts (DODs). |
| Current Account | Having a Current Account is not mandatory. | Having a Current Account is mandatory. |
| Interest | Interest is calculated on the full sanctioned amount. | Interest is calculated on the amount utilised from the credit line. |
| Repayment | It has a fixed repayment schedule in the form of Equal Monthly Instalments (EMIs). | The borrower can repay the amount borrowed when they have the capacity to. |
Term Loan Vs Overdraft Facility – A Detailed Explanation
Both is an option for small businesses or individuals, based on the demands and specifications of the enterprise. However, students must first comprehend the advantages and disadvantages of both before drawing any conclusions.
What is Term Loan?
Term loans are loans sanctioned by Banks/NBFCs for a fixed tenure at an interest rate. The interest rate could either be fixed, or fluctuating. If the interest rate is fixed, it is usually linked to a benchmark interest rate (like the repo rate of the RBI).
The term loan taken must be repaid within the tenure of the loan with a fixed repayment schedule, also called Equal Monthly Instalments (EMIs).
The EMI consists of both the interest payment, as well as a part of the principal amount.
In case the loan is prepaid, or the borrower does not adhere to the schedule of repayment, a penalty may be levied by the lender.
A term loan is of 3 types-
- Short-term– Less than one year.
- Medium-term– One to Five years.
- Long-term– More than five years.
Advantages of Term Loan
- Tenure of the loan could be chosen by the borrower as per their repaying capacity. Term loans are usually for the long-term, which allows prepayment in small instalments.
- Loan amount sanctioned is higher as compared to other products.
- Having a Current Account is not mandatory.
- Does not have to be renewed once the loan is sanctioned.
Disadvantages of Term Loan
- The repayment schedule is fixed and may entail a penalty if not adhered to.
- Interest is levied on the full amount sanctioned for the loan, and not the amount used by the borrower.
- In case of a fluctuating interest rate, the interest rate could be to the detriment of the borrower.
What is Overdraft Facility?
An Overdraft Facility is a form of Credit Line provided to businesses for a charge, to take care of their working capital requirements. Usually, the lender sanctions a credit limit to the borrower in their Current Account based upon their financial profile, from which the borrower could borrow money as and when the need arises.
An Overdraft Facility could either be secured or unsecured and interest is levied on the amount utilised by the borrower from the sanctioned credit limit and is calculated on a daily basis. The interest rate in an Overdraft Facility is mostly fixed.
The amount utilised by the borrower could be paid back by them as and when they have the capacity to without incurring any prepayment charges.
An Overdraft Facility is of 2 Types-
- Standard Overdraft (OD)- It is a credit line provided to the borrower at an agreed rate of interest with an upper borrowing limit. It must be renewed each year.
- Drop-line Overdraft (DOD)– It is a credit line offered to the borrower for a specified tenure with the sanctioned borrowing limit decreasing each month. It need not be renewed each year.
Advantages of Overdraft Facility
- Flexible repayment option as per the convenience of the borrower.
- No prepayment charges or a penalty.
- Interest is levied only on the amount used by the borrower, and not the sanctioned loan amount.
Disadvantages of Overdraft Facility
- An Overdraft Facility must be renewed each year, except in the case of Drop-line Overdrafts.
- It does not address the long-term fund requirements of a business.
- Mandatory to have a current account.
Which One is Better for You – Overdraft facility or a Term Loan?
Since the nature as well as features of both the debt instruments are quite different, their applicability also differs.
If a business is in need of funds for its working capital, an overdraft facility would be a suitable option since it allows the borrower to utilise money from the Overdraft Account as and when needed. Thus, money could be borrowed multiple times within the sanctioned borrowing limit as long as the Overdraft Facility is valid.
On the other hand, a term loan offers lower interest rates if the tenure is relatively long and the loan is secured (collateralised). Thus, it is suitable for businesses with long-term requirements or for debt consolidation to improve the debt-related ratios of a business.
Thus, the usage of both the instruments is different. An overdraft facility could be quite useful if the business needs the funds for recurring expenditures (like payment of salaries, purchase of raw materials, etc.), while a term loan would be the apposite option for business expansion or new investments.
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FAQs related to Term Loan vs Overdraft Facility
Q.1 What is the difference between a term loan and an overdraft loan?
- A term loan is usually sanctioned for a specified tenure at a fixed or fluctuating interest rate, while an Overdraft loan can be taken anytime at an agreed interest rate from the sanctioned overdraft limit as per the need of the borrower and repaid as per their convenience.
- A prepayment penalty is not levied on an Overdraft loan, while it is levied on a term loan.
- While it is mandatory to have a Current Account for an Overdraft Loan, it is not mandatory for a term loan.
Q.2 What is the advantage of an Overdraft?
An advantage of an overdraft is that there is no prepayment penalty, unlike a term loan. At the same time, an overdraft allows the borrower to borrow money multiple times during a year as per their requirement. The interest is thus levied on the actual amount borrowed for the number of days the borrowed amount was outstanding.
Q.3 What are the 3 types of term loans?
The three types of term loans are-
- Short-term: It is a loan with a tenure of less than a year (12 months).
- Medium-term: It is a loan with a tenure ranging from a year to 5 years.
- Long-term: It is a loan with a tenure which is more than 5 years.
Q.4 Is Bank Overdraft better than a loan?
A bank overdraft is usually better than a loan since the interest is levied on the amount utilised by the borrower, unlike a loan wherein the interest is levied on the complete amount sanctioned. The borrower can also prepay the borrowed amount from their Overdraft Account without any penalty, which may not be the case with a loan.
