Business Loan vs Business Overdraft: What’s the Difference?
Business loans and overdrafts can both provide businesses with additional working capital, but they work in quite different ways.
A business loan normally provides a fixed amount of money that is repaid over an agreed period.
A business overdraft provides a flexible credit limit attached to a business bank account, allowing the company to borrow when its account balance falls below zero, up to the agreed limit.
The right option depends largely on why you need the money, how long you expect to need it and how predictable the funding requirement is.
How does a business loan work?
With a business loan, the lender advances an agreed amount to the business.
For example, a company might borrow £50,000 and repay it over 24 months.
The loan will normally have an agreed:
loan amount;
repayment period;
interest rate or other cost;
repayment frequency; and
repayment schedule.
Depending on the product, repayments might be monthly, weekly or follow another agreed schedule.
Because the amount and repayment period are established at the beginning, the business generally knows how much it needs to repay and when.
How does a business overdraft work?
A business overdraft works differently.
Rather than receiving a fixed loan, the business is given permission to borrow through its current account up to an agreed limit.
For example, a company with a £50,000 overdraft could potentially move between a positive bank balance and an overdrawn position of up to £50,000.
If the business only uses £15,000 of the facility, interest will generally be calculated on the amount actually drawn rather than the entire £50,000 limit, although fees and charging structures vary between banks.
When customers pay the business, those receipts automatically reduce the overdrawn balance.
This makes an overdraft particularly suited to short-term fluctuations in working capital.
What is the main difference?
The fundamental difference is fixed borrowing versus flexible borrowing.
With a loan, the business receives a defined amount and then repays it according to an agreed schedule.
With an overdraft, the business has access to a credit limit and can move in and out of borrowing as its cash position changes.
Business loan | Business overdraft | |
Structure | Fixed advance | Flexible credit limit |
Funds | Usually advanced at completion | Drawn when required |
Repayments | Agreed schedule | Balance reduces as funds enter account |
Interest | Based on loan terms | Generally based on amount utilised |
Best suited to | Defined funding requirement | Fluctuating working capital |
Term | Usually agreed in advance | Often subject to ongoing review |
Certainty | Greater repayment certainty | Greater borrowing flexibility |
Exact terms vary between lenders and banks.
When is a business loan more appropriate?
A business loan can work well where there is a specific funding requirement.
For example, a company might need:
£75,000 to purchase equipment;
£40,000 to refurbish premises;
£30,000 to purchase stock;
£100,000 to fund expansion; or
£50,000 to support the mobilisation of a new contract.
In each case, the business has a reasonably identifiable funding requirement.
A loan allows that expenditure to be funded upfront and the cost to be repaid over an appropriate period.
When is an overdraft more appropriate?
An overdraft can be particularly useful where the funding requirement moves up and down.
Consider a business that invoices customers at the end of each month but pays wages every Friday.
It might periodically experience a £20,000–£30,000 cash shortfall while waiting for customer payments.
Once those customers pay, the cash position returns to normal.
An overdraft can be well suited to this type of recurring working-capital cycle because the business only draws the facility when required.
Is an overdraft cheaper than a business loan?
Not necessarily.
The cost structures are different.
An overdraft can be efficient where the business only uses the facility occasionally because interest is generally charged on the amount actually borrowed.
However, overdrafts can also involve:
arrangement fees;
renewal fees;
interest;
other account charges; and
potentially higher pricing for unauthorised borrowing.
A loan may have interest and arrangement fees but provides greater certainty over the repayment schedule.
The appropriate comparison is therefore the expected total cost based on how the business will actually use the facility.
Can an overdraft be withdrawn?
Potentially, and this is an important distinction.
Business overdrafts are generally subject to the bank's terms and may be reviewed periodically.
Depending on those terms and the circumstances, a bank may reduce or withdraw an overdraft facility.
This can create a problem if the company has come to rely on the overdraft as a permanent source of capital.
A term loan generally provides greater certainty because the agreed borrowing is scheduled to remain outstanding and amortise over the contractual term, provided the borrower complies with the loan agreement.
Should an overdraft always return to credit?
There is no absolute rule, but an overdraft is generally most naturally used to manage temporary cash-flow fluctuations.
If a business has a £50,000 overdraft and continually operates £45,000–£50,000 overdrawn, the facility is effectively funding a permanent requirement rather than temporary fluctuations.
That may indicate that a term loan or another form of longer-term finance would be more appropriate.
It can also matter when applying for additional finance.
A lender reviewing bank statements may distinguish between a business that occasionally uses its overdraft and one that is permanently operating at its limit.
Can I have a business loan and an overdraft?
Yes.
The two facilities can serve different purposes.
For example, a business might use:
A £100,000 term loan to finance new equipment over several years.
and
A £30,000 overdraft to manage short-term fluctuations between paying suppliers and receiving customer payments.
This can be a sensible funding structure because the duration of the finance broadly matches the purpose for which it is being used.
However, lenders considering additional borrowing will take existing commitments into account when assessing affordability.
Does an overdraft affect how much I can borrow?
Potentially.
A lender considering a new business loan will normally want to understand the company's existing financial commitments, including overdraft facilities.
Both the overdraft limit and actual utilisation can be relevant.
For example, a £50,000 overdraft that is rarely used presents a different picture from a £50,000 facility that remains fully drawn throughout the month.
Persistent overdraft utilisation can indicate limited liquidity and may reduce the amount of additional borrowing the business can comfortably support.
Is a revolving credit facility the same as an overdraft?
Not exactly, although they share some characteristics.
A revolving credit facility provides an agreed amount of funding that can be drawn when required rather than necessarily being advanced in full at the outset.
Unlike a traditional overdraft, it doesn't necessarily sit directly within the company's current bank account.
The detailed mechanics vary considerably between products.
Both can be useful where a business has recurring rather than one-off funding requirements.
What if I only need money for a few months?
A short-term business loan may be another option.
Rather than maintaining an overdraft facility indefinitely, the business borrows a specific amount and repays it over a relatively short period.
This can be appropriate where the business knows:
how much it needs;
why it needs it; and
when the cash flow required to repay it is expected.
However, shorter repayment periods mean higher regular repayments, so affordability is particularly important.
Which gives me more certainty?
Generally, a term loan provides more certainty over the borrowing period and repayment schedule.
An overdraft provides greater flexibility over how much is actually being borrowed at any particular time.
That produces a useful distinction:
Loan = certainty of funding and repayment schedule.
Overdraft = flexibility of utilisation.
Which matters more depends on the company's circumstances.
How should I choose between a loan and an overdraft?
Start with the purpose of the funding.
If the requirement is a specific amount for a defined investment or expenditure, a business loan may be more appropriate.
If the requirement regularly fluctuates as part of the company's working-capital cycle, an overdraft may be more suitable.
Then consider:
amount required;
expected period of borrowing;
repayment affordability;
frequency with which funding will be needed;
total cost;
flexibility;
security or personal guarantee requirements; and
certainty that the facility will remain available.
The cheapest headline interest rate doesn't necessarily identify the most appropriate facility.
Business finance from Adelpha Capital
Adelpha Capital provides business finance to established UK SMEs.
We consider the purpose of the borrowing alongside the company's turnover, cash flow, recent bank conduct, trading history and existing financial commitments when assessing an application.
If a term loan is appropriate for your funding requirement, you can apply online or contact the Adelpha Capital team to discuss your requirements.