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Business overdrafts vs business loans: the pros and cons

Business loans and business overdrafts are two popular finance options. But which one is best for small businesses? Find out why we think a business loan could prove advantageous to your business below.
Business overdrafts vs business loans: the pros and cons

The news that overdraft interest rates are set to skyrocket from April 2020 onwards is giving everyone pause for thought, raising the question: is it cheaper to get a loan or an overdraft?

The change in overdraft costs is happening because the Financial Conduct Authority (FCA) discovered that banks were reaping huge profits from them. But the enforced change to a fixed rate of interest has led to many banks charging 40 per cent – around double the cost of many credit cards.

The FCA claims that seven out of 10 overdraft users will see no change in what they pay for their overdraft or be better off, and say that the new rules only affect personal banking rather than business accounts.

But the shake-up has nevertheless prompted businesses that rely on overdrafts to assess their options. After all, a bad credit score brought about by missed personal overdraft payments could affect your chances of getting a business loan. Where, then, do business overdrafts slot into the small-business finance equation?

If you're contemplating whether a business loan or overdraft facility is better suited to your company's needs, the following pros and cons are worth keeping in mind.

Business overdrafts: the pros & cons

A business overdraft works in much the same way as a personal one, allowing companies to access funds even when their account balance drops to zero. Business overdraft rates are typically linked to the Bank of England base rate on a variable or tracker basis.

The benefits and advantages of a business overdraft include:

  • If you accidentally drop into the red, you're covered immediately by your overdraft- giving you peace of mind during busy periods.
  • If you're only dipping into your overdraft occasionally and for short periods of time, it will provide you with flexible, affordable working capital.
  • You can speak to your bank about a tailored overdraft agreement, and you can close your overdraft at any time.

There are, however, a number of disadvantages to a business overdraft, including:

  • If you are using an overdraft over a longer period of time and borrowing large amounts with it, your interest rates will be high.
  • There are various fees associated with overdrafts, with various banks charging set-up charges, application fees, annual or monthly overdraft fees, and late payment charges.
  • While overdrafts are flexible, banks can cancel them with very little or even no notice and this can have serious implications for your business.

Business loans: the pros & cons

Business loans differ from overdrafts in that they represent a single, capital sum that is repaid in agreed instalments over a set period of time. There are various types of business loan; the main two being secured and unsecured, and you can take out an amount of money that suits your company's needs.

The main advantages of a business loan when compared to an overdraft is that they generally grant access to a much larger sum of money. With more funds, you could look to:

  • Purchase fixed assets for your company, such as equipment or property.
  • Cover the fixed portion of your working capital; taking care of your day-to-day running costs.
  • Expand your team.

As a loose guide, business loans often don’t come with costly set-up fees, whereas many business overdrafts do. With overdrafts, the bank can request repayments immediately and without warning- whereas typically with business loans, your monthly repayment schedule is more predictable.

A potential downside of a business loan is the possibility of not having your application accepted. The minimum amount of money you can take out with a business loan is often much higher than an overdraft, too, so businesses that only require extra funds to cover a small seasonal trough in cash flow might opt for an overdraft.

Business loan vs overdraft: the conclusion

Bank overdrafts have long been seen as a reliable safety net, but in the current economic climate many businesses view loans as a safer, more predictable option.

When weighing up whether a business overdraft or loan might suit your needs better, it is important to take into account your business credit score, your cash flow and the purpose for which you intend to use the overdraft or loan.

Once you have these factors clearly established, you are ready to start exploring your options- and look for a quote.

How could Esme Loans help?

Fortunately, at Esme, we make getting a quote for a business loan easy. We provide unsecured loans to businesses from £10,000* to £250,000 over a one to five year repayment period with no set up costs or early repayment fees.

Get your instant quote on our website to see how much your business could borrow. 99% of customers who go on to successfully apply receive the rate they were quoted.

*From £25,500 for Sole Traders