LOANS AND OVERDRAFTS

A loan refers to a fixed amount lent out to borrowers by a lending institution for s fixed term. The loan payments can be made on a monthly or annual basis. The repayment amount consists of the principal and the interest. The interest represents the cost of borrowing and the rates are influenced by the central bank regulations. On the other hand, an overdraft refers to an amount of funds extended to a borrower even when his/her account has no funds. Therefore, the borrower continues to withdraw funds in spite of the inadequacy of funds in his/her account to cover the amount withdrawn. As a condition of the overdraft, the borrower is expected to pay a particular amount of interest either monthly or annually. For financial institutions to issue loans or overdrafts, they have to verify the creditworthiness of the borrower.

Some of the distinguishing features of a loan are time to maturity and security. Time to maturity refers to the time span of the loan. Loans can be classified in terms of their contract lengths as short term, intermediate or long term loans. Another characteristic is that loans require assets that are used as collateral. Thus, loans can be classified as either secured or unsecured. A secured loan is one that requires collateral while an unsecured loan is one that does not require collateral and tends to have a higher interest compared to an unsecured loan. The collateral acts as a security for any loss in case the borrower defaults in payment of the loan. An overdraft loan is suitable to cover short term cash flows in case of emergencies. For instance, when the bills are due and the date of payment is not yet, bank overdrafts can be of help. However, bank overdrafts are not suitable for accumulating huge long term debts. Other advantageous features of bank overdrafts are that interest is only charged on the amount withdrawn and they lack a fixed repayment schedule.