Understanding Key Differences Between Term Loan and Overdraft

Businesses require financial solutions to address varying needs—whether funding an expansion, managing cash flow, or tackling unforeseen expenses. Among the most widely used financial products are term loans and overdrafts. While term loans cater to long-term investments with structured repayments, overdrafts offer flexible, short-term liquidity to address immediate requirements. 

The India Digital SME Credit Report 2023 reveals a $220 billion credit gap in SME funding, with only 30% of demand met through traditional financing. This data underscores the critical need for tailored financial instruments, such as term loans and overdrafts, to help address these challenges and support the growth of MSMEs and startups.

In this article, we delve into the differences between term loans and overdrafts and explore their advantages and limitations.

To better understand their distinct roles, refer to the table below.

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Key Differences Between Term Loans and Overdrafts

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What is a Term Loan?

A term loan is a traditional borrowing method where a fixed sum is disbursed upfront and repaid over a specified tenure in regular installments. Businesses typically use term loans for planned, long-term investments, such as purchasing assets or funding expansions. 

In this context, Recur Club has been instrumental in supporting over 1,000 startups by providing unsecured term loans with an industry-leading turnaround time (TAT) of less than 5 days. This swift and seamless funding solution ensures businesses can focus on their growth initiatives without delays or cumbersome processes.

Key Features of Term Loans

1. Fixed Loan Amount and Tenure

Term loans are structured around the borrower's financial requirements and repayment capacity. Repayment periods can range from 1 to 10 years or even longer for large-scale infrastructure projects. For instance, a real estate developer constructing a commercial complex may secure a ₹5 crore term loan with a 15-year repayment tenure.

2. Collateral Requirements

Secured term loans require collateral, such as property or equipment, offering lower interest rates due to reduced lender risk. For instance, SBI’s business loan scheme provides up to ₹20 crore against collateral.  Unsecured term loans, while not requiring collateral, come with higher interest rates and stricter eligibility criteria, making them suitable for businesses without significant assets to pledge.

3. Interest Charged on the Entire Loan Amount

Interest accrues from the date of disbursement, even if the funds are utilized in phases. Borrowers can choose between fixed or floating interest rates, depending on market conditions.

4. Structured Repayment Schedule

Fixed EMIs (equated monthly installments) enable predictable cash flow management. Some lenders, like HDFC Bank, offer flexible repayment structures, such as balloon payments for businesses with fluctuating income.

Advantages of Term Loans

1. Cost Efficiency

Lower interest rates compared to overdrafts make term loans an economical choice for substantial funding.

2. Higher Loan Amounts

Term loans cater to significant investments, often exceeding the limits of other financing tools.

3. Tax Benefits

Interest paid on business loans is tax-deductible under Section 36(1)(iii) of the Income Tax Act if the loan is exclusively used for business purposes. Proper documentation is required to claim this benefit.

Disadvantages of Term Loans

1. Collateral Requirements

The need for collateral can limit accessibility for smaller businesses or startups with fewer assets.

2. Prepayment Penalties

Lenders often impose penalties for early repayment, reducing flexibility.

3. Long Approval Process

Extensive documentation and credit evaluations can delay fund disbursement.

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What is an Overdraft?

An overdraft is a flexible credit facility linked to a business’s current account, allowing withdrawals beyond the available balance, up to a sanctioned limit. Overdrafts are particularly useful for businesses with unpredictable cash flow cycles.

Key Features of Overdrafts

1. Revolving Credit Line

Overdrafts provide businesses with a revolving credit line, allowing withdrawals up to an approved limit as needed, without the need to reapply for new credit. For instance, a retail store with a ₹10 lakh overdraft can draw ₹5 lakh during lean months and repay it as sales improve.

2. Interest Charged Only on Utilized Amount

Unlike term loans, where interest is charged on the full loan amount, overdrafts charge interest only on the amount utilized. This feature helps businesses manage costs efficiently by paying interest only on the drawn amount, rather than on the entire credit limit.

3. Flexible Collateral Requirements

Overdrafts can either be secured or unsecured, depending on the lender's assessment of the borrower's creditworthiness. Secured overdrafts typically come with lower interest rates and higher credit limits. Common forms of collateral include fixed deposits or real estate.

4. Higher Interest Rates

Overdrafts tend to carry higher interest rates compared to term loans, generally ranging from 10% to 18% annually, due to their flexible and immediate access to funds.

5. No Fixed Repayment Schedule

One of the key features of overdrafts is that they don’t have a fixed repayment schedule. Borrowers can repay the borrowed amount at their convenience, provided they adhere to the terms agreed with the lender.

Advantages of Overdrafts

1. Unmatched Flexibility

Overdrafts allow businesses to borrow only what they need, reducing unnecessary debt accumulation.

2. Cost-Effective for Short-Term Needs

Interest applies solely to the utilized amount, making overdrafts economical for short-term cash flow gaps.

3. Quick Access to Funds

Overdrafts offer immediate liquidity, enabling businesses to address urgent operational needs without delays.

4. Versatile Usage

Funds can be used for diverse purposes, from managing seasonal demands to covering unexpected expenses.

Disadvantages of Overdrafts

1. Lower Credit Limits

Overdraft limits are typically lower than term loan amounts, restricting their utility for large-scale investments.

2. Dependency on Banking Relationships

Approval often depends on the borrower’s existing relationship with the bank and account history.

3. Risk of Over-Reliance

Businesses may risk becoming dependent on overdrafts, leading to potential financial instability.

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Choosing Between Term Loans and Overdrafts

Selecting the right financial product for your business depends on your specific needs, cash flow, and the type of expense you're addressing. Here's how to differentiate between term loans and overdrafts:

1. Purpose: Term loans are perfect for long-term, large-scale investments like buying equipment or expanding infrastructure. Overdrafts, however, are best for managing short-term liquidity issues, helping you bridge cash flow gaps without the need for long-term commitment.
2. Repayment Flexibility: With term loans, repayments are fixed and predictable, making them a good fit for businesses with steady income. In contrast, overdrafts offer greater flexibility, as you only need to repay based on your available cash flow, without a rigid repayment schedule.
3. Speed and Access: Term loans require more paperwork and a longer processing time but provide larger funding amounts. Overdrafts offer quick access to funds with fewer formalities, allowing businesses to meet immediate financial needs efficiently.

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Conclusion

When it comes to choosing the right financial solution for your business, the flexibility of overdrafts and the structured reliability of term loans cater to specific needs. However, navigating these financing options can often feel overwhelming due to complex terms, lengthy processes, and uncertainty in finding the right lender.

This is where Recur Club stands as a game-changer. With expert-led advisory, Recur Club simplifies the financing journey, empowering businesses to focus on their growth while leaving the complexities of fundraising to the experts.

Whether your business requires structured-term loans for large-scale investments or the flexibility of overdrafts, we help connect businesses with over 100 leading lenders, including Tata Capital, HSBC, and Aditya Birla Capital to bridge short-term liquidity gaps or fund long-term investments efficiently.

Discover the perfect financing solution for your business with Recur Club—get started today and secure the capital you need to thrive.