Payday loans and overdrafts are very common ways to borrow though each has a very different purpose. Overdrafts tend to be used for day to day cashflow management, whereas payday loans are designed to help with one-off emergency expenses or temporary cashflow shortfall between paydays. To compare the borrowing options, you need to consider various factors including your own personal financial circumstances and why you need to borrow.

Definition of a Payday Loan

A payday loan is a type of high cost short term credit. Generally, you can borrow up to £1000 for up to 12 months and the annual percentage rate (APR) is over 100%, although this doesn’t mean you repay more than 100% of what you borrow. Commonly, people borrow payday loans for between 3 and 6 months and these loans are referred to as instalment loans.

Definition of an Overdraft

An overdraft is an attachment to your current account that lets you withdraw funds from your bank account into a deficit. An arranged overdraft has a pre-agreed limit with your bank. An unarranged overdraft means there is no agreement in place with your bank.

When we discuss overdrafts in this article, we refer to arranged overdrafts only.

Main differences between payday loans and overdrafts

  • Applications: you only need to apply for an overdraft once and most people get an overdraft automatically when they open a bank account. Payday loans require a new application each time you want to borrow, though the applications usually only take a few minutes to complete, and as most payday lenders offer online loans, the applications can be submitted 24/7.
  • Repayments: overdrafts have a running account set up which means the fees are applied for each month that you’ve borrowed, unless you have a 0% interest rate agreed. Payday loans have set repayment amounts and dates that are agreed when you sign your loan agreement. Some lenders will allow you to amend the repayment dates and all payday lenders will help you set up a repayment plan if the repayments become unaffordable.
  • Interest rates: overdrafts have an agreed interest rate though the bank can change it at any stage while you have an account with them. Most banks offer a “free overdraft” limit, usually between £250 and £500, whereby no interest or fees are charged – even if you sit permanently within that limit. Payday loans are a form of high cost credit which means they have an APR over 100% (usually in the 1000% range), although an easier way to calculate how much interest is charged might be by using the per annum rate (PA). Payday lenders cannot charge more than 80p per £100 per day. Until the overdraft reform in 2019, this was up to 10 times cheaper than unarranged overdrafts at some banks.

Reasons for Overdrafts and Payday Loans

Ultimately, there are different types of credit because there are different reasons to borrow. You wouldn’t need a mortgage to buy a car, for example, in the same way you wouldn’t be able to buy a house on a credit card.

Overdrafts are a form of revolving credit which means you can manage your cashflow for monthly or even day to day purposes. If you have an irregular income or your direct debits don’t align with your paydays, then arranged overdrafts can be a cheap way to ensure you meet all of your financial commitments on time – especially if you stay within your 0% interest rate limit.

However, if you only ever need to borrow occasionally, or you know you can be tempted to spend more than you earn from time to time, then having an overdraft can hinder your ability to manage your money. Instead, a short term loan might be more beneficial as you can’t continuously borrow, and you have static repayment amounts allowing you to budget more accurately.

It’s important to remember that payday loans are more expensive than overdrafts, but they could be easier for some customers to manage. Both borrowing options have their benefits and disadvantages which is why it’s important to find a credit product that suits your circumstances.

Things to consider before applying for credit

Regardless of the type of loan or credit that you use, there are certain things that you should always consider before submitting an application. These easy checks can help ensure you only borrow when you need to and that you don’t take out credit that you can’t afford.

Is the payment urgent?

Using credit for unnecessary purchases can make managing your finances harder in the long run. It can also reduce the credit available to you when you really need it. If the purchase can wait until you next get paid, then you shouldn’t look to borrow money to finance it.

Check your budget

When faced with an urgent expense, it’s not difficult to forget all other financial commitments in the panic. But taking out credit without properly considering your current and future financial circumstances can lead to missed payments and arrears. Don’t just think about your regular payments but check if you have any one-off or annual bills coming up too.

Submit an honest application

If you’re not sure of the exact figures for your income and expenditure, look at a recent bank statement to check. Entering incorrect information could actually get your application declined as lenders check several sources of information to verify the details you submit.

Alternative Types of Credit

When thinking about where to borrow money, it can be easy to choose the same options over and over again. But just because you have used a particular loan service or credit product before, it doesn’t mean there aren’t other options available which might be better suited to your particular circumstances.

Overdrafts and payday loans are two very common ways to manage cashflow for different reasons, but other services like credit cards for people who have a bad credit history, or even credit lines can also help you manage your money in times of emergency payments or unexpectedly high bills. Doing some research prior to applying for credit could help you find a loan that works for you and could help you save money too.