Overdraft, revolving credit or a loan: which suits your business?

Most businesses need borrowed money for two quite different reasons. Some needs are one-offs: a new machine, a refit, buying out a partner. Others recur: wages due before customers pay, stock bought ahead of a busy season, a big supplier invoice every quarter.

Overdrafts, revolving credit facilities and term loans each fit one of those patterns better than the others. Using the wrong one is a common, and avoidable, source of trouble.

How a business overdraft works

An overdraft lets your business current account go below zero, down to an agreed limit. You don't apply each time you need money. You simply pay for things as normal, and if the balance dips below zero, you're using the overdraft. When money comes in, the overdraft is repaid automatically.

• Interest is charged only on the overdrawn balance, usually worked out daily and taken monthly. The rate is often variable.
• Fees. Many banks charge an arrangement fee when the overdraft is set up and a renewal fee each time it's reviewed, often yearly.
• Going over the limit usually costs more, through higher charges or interest, and payments may be returned unpaid.
• Security. Smaller overdrafts may be unsecured. Larger ones may need a personal guarantee or security over the business's assets.

The catch is that a business overdraft is usually repayable on demand. Read your terms, but in most cases the bank can reduce your limit or withdraw the overdraft altogether, and ask for the money back, without waiting for a review date. In practice, banks most often make changes at the annual review, but they don't have to wait.

How a revolving credit facility works

A revolving credit facility (RCF) also gives you a limit to draw on, but it sits separately from your current account. You ask for money when you need it, the lender pays it into your account, and you repay when you can. Whatever you repay becomes available to draw again, which is what "revolving" means.

• Interest is charged on what you've drawn, not on the full limit.
• Fees. Expect an arrangement fee, and sometimes a commitment or non-utilisation fee: a smaller charge on the part of the limit you haven't used.
• Term. The facility is usually agreed for a set period, after which it has to be renewed or repaid.
• Commitment. Many RCFs are committed facilities: the lender has agreed to make the money available for the term, as long as you keep to the conditions in the agreement. That gives you more certainty than an overdraft, though renewal at the end of the term isn't guaranteed.

Some lenders offer variations under names such as "flexible business credit" or "line of credit". With some of these, each amount you draw is repaid in fixed instalments over a set number of months, a bit like a series of small loans. Check how each drawdown is repaid before you compare it with a classic RCF.

How a term loan works

A term loan pays you a lump sum, which you repay with interest in fixed instalments, usually monthly, over an agreed term. Interest is charged on the whole outstanding balance from the day the money arrives, falling as you pay it down.

You can't redraw what you've repaid. If you need more money later, you'll need a new loan or a top-up. In return, a term loan gives you certainty: fixed repayments if the rate is fixed, and, as long as you keep to the terms, the lender generally can't ask for the money back early. Our guide to what a business loan really costs explains how to compare loan offers.

What each one costs

Comparing these three on interest rate alone can mislead you, because you use them differently.

With a term loan, you pay interest on the full amount from day one, whether or not you've spent it yet. With an overdraft or RCF, you pay interest only on what you're using, but you may pay fees for having the limit available, and the rate per pound borrowed is often higher than a loan's.

So the real question is how much you'll actually borrow, and for how long.

An illustration, not a quote. Say your business needs about £30,000 for three months each spring, to buy stock before the busy season. To keep it simple, assume every option charges interest at 1% a month.

A one-year term loan for £30,000 would cost about £1,990 in interest over the year. But you only needed the money for three months, so for most of the year you'd be paying interest on cash you didn't need.

A revolving facility with a £30,000 limit, drawn in full for three months and then repaid, would cost about £900 in interest, plus any arrangement and non-utilisation fees. Next spring, you can draw it again without a new application.

In real life the rates and fees will differ between products. The point is the shape: for a need that comes and goes, paying interest only on what you use can make a flexible facility cheaper even at a higher rate.

The opposite applies to a long-term need. If you draw an overdraft or RCF and never repay it, you're paying a flexible-facility price for what is really a loan, and you have less security than a loan would give you.

Flexibility, renewal and the risk of losing the facility

This is where the three differ most, and it matters more than the price.

• Overdraft. The most flexible, because it works automatically. Also the least secure. Because it's usually repayable on demand, the bank can cut or withdraw it, and it's typically reviewed every year. Banks tend to look harder at an overdraft that's always fully used, if the business's results have weakened, or when economic conditions are tight, which is often exactly when you need it most.
• Revolving credit facility. Flexible within its limit and, if committed, secure for its term as long as you keep to the conditions. Those conditions may include financial tests, known as covenants, such as minimum levels of profit or cash. Renewal at the end of the term depends on how the business looks then.
• Term loan. Not flexible at all, but the most predictable. You know what you'll pay and when, and the money can't be withdrawn while you keep to the terms.

A practical rule: never rely on an overdraft to fund something you couldn't quickly repay if the bank asked. If losing your overdraft would cause a crisis, that's a sign some of it should be a loan.

Which suits which need

Some needs fit none of these perfectly. If customers paying late is the cause, invoice finance releases money tied up in unpaid invoices and grows with your sales. For seasonal peaks, see our guide to stock and seasonal finance.

Common mistakes to avoid

• The permanent overdraft. If you've been overdrawn for months without ever returning to credit, you have a loan with none of a loan's security. Turning that "hardcore" balance into a term loan can be cheaper and safer. See refinancing business debt.
• Funding a long-term purchase with a short-term facility. Paying for equipment or a refit with an overdraft leaves you exposed if the limit is cut.
• Taking a loan for a recurring gap. You pay interest on money you don't need for much of the year, and you're back for another loan next time.
• Ignoring the fees on unused limits. A large facility you rarely use can cost more than a smaller one.
• Not reading the review and repayment terms. Know whether your facility is repayable on demand, when it's reviewed and what conditions it carries before you rely on it.

Questions people ask

What's the difference between an overdraft and a revolving credit facility?

An overdraft is attached to your current account and is used automatically when your balance goes below zero. A revolving credit facility is a separate limit you draw from when you choose. Overdrafts are usually repayable on demand, while many revolving facilities are committed for a set term as long as you keep to the conditions.

Can a bank take away a business overdraft?

Usually, yes. Most business overdrafts are repayable on demand, so the bank can reduce or withdraw the limit and ask for the money back. Banks often make changes at the annual review, but your terms will say whether they have to wait.

Is an overdraft cheaper than a business loan?

It depends on how you use it. Because you only pay interest on what you're using, an overdraft can be cheaper for short, occasional dips. If you stay overdrawn for months, a term loan is often cheaper and gives you more security.

When is a term loan better than revolving credit?

A term loan suits a one-off cost with a clear price, such as equipment, a refit or an acquisition. It gives you fixed repayments and certainty that the money won't be withdrawn while you keep to the terms. Revolving credit suits needs that come and go.

Do I pay interest on the unused part of a revolving credit facility?

You don't pay interest on money you haven't drawn. Some lenders do charge a smaller fee on the unused part of the limit, often called a commitment or non-utilisation fee, so check the agreement.