Most businesses – irrespective of their size, nature, or industry – have to borrow money at some point in their lifecycle. Be it to get off the ground, expand operations, or to weather a rough patch – borrowing is a crucial and essential part of all businesses. The variety of loan options available to business owners can be bewildering, especially if this is the first time you're borrowing outside.
One common question that most entrepreneurs and business owners ask is, "which should I choose – business loans or overdraft? Which is the better choice for me?" The answer to this question is not simple. The right product depends on your business's financials and your needs. Here, in this guide, we take a closer look at the features, pros, and cons of both these products, helping you arrive at the right choice.
What is a business loan?
A business loan is an unsecured loan that you avail from a bank, NBFC, or other digital lenders to meet various business needs. Some instances when you can opt for business loans include:
For business expansion
To meet working capital needs
To invest in machinery, infrastructure or property for your business
For hiring additional staff
For purchasing raw material or stocking inventory
For training employees, etc.
Business loans can be taken for short to long-term, depending on your needs. Generally, these loans are offered for tenures ranging from one year to ten years.
How does it work?
When you apply for a business loan, the lenders allow you to borrow a bulk amount of money. You then repay the loan amount (principal) along with interest in the form of fixed monthly EMIs. The amount that you're eligible for depends on several factors like – the borrower's profile, business vintage, years of experience, financial status, credit history, credit scores, etc.
Business loans can be classified into two broad types:
Secured loans – Here, you pledge collateral or asset, to get the loan.
Unsecured loans – These loans do not require you to submit any collateral. However, the interest rates of unsecured loans are higher compared to secured loans.
What is an overdraft (OD)?
There may be times when your current account runs out of funds, and you're unable to issue cheques to suppliers or pay your workers. This is where an overdraft comes in handy. To explain it in simple terms, an overdraft is an extension provided by your bank. Using this facility, you can withdraw money from your bank account (up to a specific limit), even when your account doesn't have funds.
According to recent RBI regulations, all current account holders and cash credit account holders are eligible for an OD of Rs. 50,000 per week. You can easily avail of this facility if you have a good credit score and make regular payments to your bank.
How does it work?
The credit limit up to which you can withdraw money from your account is known as overdraft limit. Once you have used funds up to this limit, you cannot withdraw any further. One significant difference between term loans and overdrafts is that overdrafts are a type of revolving credit. Instead of repaying the borrowed amount within a specific tenure, in an OD, you can continue borrowing and repaying at the same time.
Generally, most banks offer OD facilities to customers who have a good rapport with the bank and repay debts on time. The OD facility can be renewed every year if you so desire. When you opt for the OD facility, you pay specific fees to the bank. When you choose an OD, you pay interest only on the extra amount you use, and not on the entire limit available for you. Since the OD is highly flexible, most businesses opt for it, even if they don't have an immediate need to borrow.
Comparison between Business Loans and Overdraft
|Definition||It is a fixed amount borrowed from the lender. It is repaid within a pre-determined tenure, along with interest.||It is a facility offered by the bank, where the customer can withdraw an amount that is greater than the amount in his/her account. The extra amount that one can withdraw is fixed up to a pre-decided limit.|
|Nature of the product||Borrowed capital||Line of credit|
|Ideal for||Long-term fund requirements||Short-term fund requirements|
|Interest charged||On the loan amount sanctioned||On the amount withdrawn from the available credit limit|
|Calculation of interest||Monthly or annual basis||Daily basis|
|Repayment||In the form of fixed monthly EMIs||In the way of deposits in the bank account|
|Bank account||Not necessary to hold a bank account with the lender||You must maintain a bank account with the borrower to avail this facility|
Which should I choose? Overdraft or Business Loans?
As mentioned above, the answer is not simple. The right product for you depends on several factors. Let’s help you make the right choice by comparing both these products under various factors.
Quantum of Loan Amount
Strictly speaking, if you’re looking for large sums, then business loans are the better choice. Consider overdrafts as credit card spending. Your business will be sanctioned a particular amount, which you can withdraw little by little, every day, based on your needs.
On the other hand, with business loans, the entire amount is made available to you in a single instalment.
Generally, the interest rates for ODs are higher than those of a business loan. However, note that in an OD, the interest is charged only on the amount that you withdraw and not the entire credit limit sanctioned to you. On the other hand, in a business loan, the interest is charged on the whole amount you borrow, irrespective of whether you utilize it or not.
Generally, ODs are sanctioned for a short-duration, say one year. You have to renew it at the end of the tenure if you require the facility for the upcoming year.
Business loans are generally available for longer terms, say 3 to 25 years, depending on the lender’s criteria.
Overdraft is ideal for regular day-to-day working capital requirements like inventory maintenance, staff salary payments, etc. Business loans are suitable for more extended and big-budget investments like acquiring machinery, business expansion, purchase of commercial property, etc.
Flexibility of Repayments
Overdrafts are more flexible when it comes to repayments. You can deposit a sum equal to the withdrawn amount in your account, to repay the OD. Business loans, on the other hand, are repaid as fixed EMIs. Failure or delay in EMI payments could pull down your credit score, impacting your ability for future credits.
Which is better?
In simple terms, business loans are best used for long-duration planned purchases. On the other hand, availing the overdraft facility offered by your bank will help in enhancing your working capital and boosting cash flow.
Though both are a type of business credit, they serve different purposes. You can opt for a business loan, overdraft, or even both depending on your business requirements and cash needs.