The Pros & Cons – Loans vs Overdrafts vs Cards vs Mortgages
One thing that can trip many people up is when to use different forms of borrowing. They each have their own characteristics so, depending on what you need the money for, one type will usually be the most appropriate while the others could turn out to be very expensive.
The most important factor to consider is the time you need to borrow for. Traditionally, overdrafts are the shortest term form of borrowing followed closely by credit cards. Personal loans are more medium term and mortgages are, of course, long term.
Let’s start with overdrafts. These are most useful if you find you only dip into the red on rare occasions and for just a few days at a time. If you find that you’re spending more than you earn each and every month and you have a core overdraft that never gets paid off, then you really need to either cut down your expenses or arrange a more permanent form of borrowing.
Overdrafts come in two main types. These are authorised, i.e. those agreed with the bank in advance, or unauthorised. As you might expect, the rates for authorised overdrafts tend to be a lot lower than for unauthorised ones. A typical difference may be 20% compared to 30%. You’ll also get hit with extra charges, usually for each day you have an unauthorised overdraft.
As an added complication, many banks are now making daily and monthly charges for overdrafts instead of charging interest. This can make an overdraft either a lot cheaper or a lot more expensive, depending on the nature of your borrowing pattern.
However, it also makes it a lot harder to compare bank accounts as you’ll need to estimate how many days you’ll be overdrawn each month rather than just being able to compare interest rates.
Overdrafts are useful, short-term borrowing tools and you don’t need to explain to your bank what you need the money for. However, the charges and rates can change at short notice and in the worst case scenario your whole overdraft could be called in. This is why you should consider other forms of borrowing if you run permanently in the red – it’s also usually a lot cheaper!
Credit cards have evolved in the last decade and become a much more flexible borrowing tool. The proliferation of 0% balance transfer deals has been the main driver but 0% purchase deals and cash back offers have played an important part too.
Matt Barrett, then chief executive of Barclays, was famously lambasted back in 2003 for saying he never borrowed on credit cards and advised his family not to either. But he wasn’t far wrong. Credit cards, like all forms of flexible borrowing, are expensive. Interest rates can be increased and credit limits can be reduced, both at short notice.
Once the introductory offers have run out, you may be able to switch to another credit card. Any debt that will take you longer than two to three years to pay off is usually better suited to a personal loan. That said, some credit cards offer lifetime balance transfer rates which can cheaper rates than personal loans and also give you more flexibility with your repayments.
Personal loans let you borrow between £1,000 and £25,000, typically for up to ten years. The great advantage they have is that the interest rated is fixed when you take out the loan, so you know exactly what your payments will be for the entire term of the loan. As long you don’t default on the repayments, then the loan they can’t be called in at short notice.
Rates for amounts over £5,000 tend to be quite reasonable, typically around a third to a half of those charged for an overdraft or on a standard credit card. Those between £3,000 and £5,000 are less competitive and those below £3,000 are quite expensive. So if you’re borrowing a small amount of money, then a credit card can be often more cost effective.
Personal loans are ideal for funding a new car, holiday or for consolidating other debts. If you’re borrowing for a particular purpose a good guide is to match the length of your loan to the life of the asset. So if you think your car will last you five years then a five-year loan makes sense. A five-year loan for a holiday is not quite so clever! All else being equal, you also want to pay back any personal loan as quickly as you comfortably can. While the interest charges are relatively low, they can soon stack up.
A mortgage is a very, very long term debt. The standard mortgage lasts for 25 years of course. In recent years it’s been fashionable to release money from your home by remortgaging either for a greater amount or for a longer time. While this can make sense in some circumstances – home improvements are probably the best example – it’s a lot more expensive than you might think.
Increasing your mortgage to fund a new car or holiday is very rarely a good idea. It’s likely that any new car will be in the scrap yard long before you’ve finished paying for it. A £10,000 personal loan repaid over 5 years will cost you around £2,000 in interest. An extra £10,000 on your mortgage will cost you £11,000 in interest. That’s over five times as much.
In conclusion, it’s worth spending a little bit of time to make sure you get the right form of debt for your borrowing needs. The amount of interest and charges you’ll save can be considerable.