When talking about sources of finance for a business you will typically hear the terms; bank loan and overdraft. However, what is the actual difference and how does a business decide when to choose a bank loan and when to choose an overdraft?
It all comes down to the time frame that the business requires the money for. For example, if the business requires the money for what we deem in business as the "long term", then a bank loan would be the chosen source of finance. Whereas, if it requires the money for the "short term" then then it would be looking at using an overdraft as the chosen source of finance.
In business we define;
- Long term finance - money that will be paid back over a period of longer than one year.
- Short term finance - money that will be paid back over a period of less than one year.
Natwest Overdraft APR
An overdraft is a short term source of finance that effectively allows a business to borrow money once their bank account goes beyond the £0 figure. You can have arranged overdrafts where you can agree a limit with the bank for how far past £0 you can go; eg; £1000. You can have un-arranged borrowing where the business just goes past £0, however rather than the bank refusing to make payments and forcing the business to shut down, it will just allow the bank account go into a negative figures (overdrawn).
The problem with using an overdraft is that the bank charges the business interest on the money that they have borrowed. Because the amount borrowed on an overdraft is meant to be small and this is only meant to be a short term source of finance, the amount of interest charged will be higher than a bank loan. So this can become an expensive form of borrowing if a business is using an overdraft for the wrong purposes. A valid use of an overdraft would be to cover a short term cash flow problem where you know the money will be coming into the business, however you need to make a payment before this will be the case.
Below is an example of a potential cash flow problem where an overdraft could enable a business to solve its cash flow issue;
The business could use an overdraft in January when it goes overdrawn as by the end of February they have paid back the overdraft and the bank account is back as a positive figure.
A bank loan will typically have a lower rate of finance (APR), however you would be typically borrowing larger sums of money over a longer period of time. This sort of finance would typically be used for purchasing larger items in the business or if the business is needing money to invest in growing the business. A bank loan should not be used to by a building though, as we have a special type of loan for this which is known as a mortgage. At the time of writing a typical bank loan would cost 3.6% APR, which is considerably less than the overdraft APR.
This is why it is vitally important for a business to choose the right source of finance. If a business is using the wrong source of finance then it could be more expensive in the longer term, which ultimately could lead to the failure of the business. Some people think that an overdraft is the best option as it is fairly easy to organise and does not require the same levels of paperwork as a bank loan, however this is not the answer and a business should always consider the APR and the cost of repayments.