Overdraft or credit card: Which is better to borrow money?
We explore how overdrafts and credit cards work to help you decide which option is right for you.
Credit cards and overdrafts are both popular ways to borrow money. However, they work in different ways, have slightly different uses and each has its own list of pros and cons. Our guide explains both, to help you choose which one could work for you.
How credit cards work
A credit card is a flexible credit line that enables you to borrow funds up to your credit limit when needed. Your credit card provider will send you a bill each month to show you how much you owe and you’ll then need to make at least the minimum payment. This will typically be 1% of your balance, plus that month’s interest, or a fixed sum of £5, whichever is greater. Because this amount is so small, it’s always best to pay off more than the minimum if you can – you’ll save in interest and pay off your debt far quicker.
Most credit cards charge interest, but some also offer 0% introductory deals allowing you to avoid paying interest for a number of months. How much you can borrow on a credit card will depend on factors such as your credit history and income. Your credit limit could be as low as £500, but if your credit history is excellent and you have a high income, you might be offered a credit limit as high as £12,000.
Different credit cards are designed for different purposes. Some enable you to spread the cost of “big ticket” items interest-free, some enable you to shift over debt from an existing credit card and pay it off more cheaply and others will offer rewards and cashback.
Credit card pros and cons
- Good for short-term borrowing.
- You might be able to take advantage of a 0% deal, helping you to spread the cost of a purchase or repay existing debt more cheaply.
- Credit card purchases over £100 (and less than £30,000) are protected by section 75 of the Consumer Credit Act. This means your card provider is jointly liable with the retailer if something goes wrong and you should get your money back.
- Credit card limits are usually higher compared to overdraft limits.
- You might be able to earn rewards such as air miles or cashback.
- Interest rates can be high if you don’t pay off your balance in full each month.
- Cash withdrawals are expensive – as well as being charged a fee, you will also be charged interest from the date of the transaction.
- The best deals are reserved for those with excellent credit scores, so if yours is not up to scratch, you could be rejected or pay a higher interest rate.
- If you don’t make your repayments on time, you can harm your credit record.
- It can take a few days for your credit card to arrive, so you won’t always be able to spend straight away.
How overdrafts work
An overdraft enables you to borrow money through your bank account. It works by letting you spend more money than you have in your account, which can be useful if you need a little extra to cover unplanned expenses. Your overdraft limit could be between £250 and £3,000, for instance.
However, an overdraft is still a type of loan and must be repaid – with interest added. There are 2 types of overdraft: arranged and unarranged. Arranged overdrafts are simply those that you’ve pre-agreed with your bank, while unarranged overdrafts are when you spend more money than you have in your account without arranging it with your bank in advance.
New rules introduced in April 2020 mean that banks can no longer charge higher fees for unarranged overdrafts than arranged overdrafts. Instead, banks must charge interest at a single annual interest rate to make it easier for consumers to compare charges. Interest rates now sit in the region of 19–40%, with most at the upper level.
Overdraft pros and cons
- Unlike a credit card, you can use an overdraft to pay direct debits and standing orders as well as to withdraw cash.
- You can repay the debt as and when you can – there are no monthly repayments.
- They are quick to apply for – in fact, often you’ll get one automatically when you apply.
- Interest rates can be very high, making it expensive.
- You usually won’t be able to borrow as much as you can with a credit card.
- Because there are no fixed monthly repayments, it can take you a long time to repay.
- Your bank can take your overdraft away at any point.
Top things to consider
When deciding whether an overdraft or credit card is best for you, you’ll need to think about your borrowing requirements. For example, if you’re looking to spread the cost of a holiday or other expensive purchase, a credit card will likely be the better choice as you’ll usually be able to borrow a larger sum. What’s more, you might be able to take advantage of an interest-free deal and you’ll also be able to benefit from valuable purchase protection through section 75.
However, if your borrowing requirements are much smaller and you’re after a bit of a buffer to cover unplanned expenses or to help you out before your next payday, an overdraft might be more suitable. An overdraft will also be better if you need to carry out a bank transfer or withdraw cash to pay for something.
Whichever option you choose, it’s crucial that you’re aware of how much interest you’ll need to pay and how much your borrowing will cost you. Only ever borrow an amount you are confident you can afford to repay.
Frequently asked questions
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