Lending Money: Overdrafts and Loans

This section explores the mechanisms by which banks lend money to individuals and businesses, focusing on overdrafts and loans. We will examine the factors influencing interest rates, the costs and benefits of lending, and the role of credit scoring.

Overdrafts

An overdraft is a short-term loan facility provided by a bank that allows account holders to spend more money than they have available in their account. It's essentially a convenient way to avoid a bounced cheque or payment failure.

How Overdrafts Work:

1. Account holders apply for an overdraft facility.
2. The bank assesses the applicant's creditworthiness.
3. If approved, the bank sets a limit on the amount of overdraft available.
4. When the account holder attempts to spend more than the available balance, the overdraft facility is automatically drawn upon.
5. Interest is charged on the amount of the overdraft used.

Cost of Overdrafts:

Overdrafts typically have relatively high interest rates compared to other forms of borrowing. This is because they are considered a short-term, high-risk facility.

Benefits of Overdrafts:

• Provides a safety net for unexpected expenses.
• Avoids the embarrassment and fees associated with bounced payments.
• Offers flexibility in managing cash flow.

Loans

A loan is a sum of money borrowed that is expected to be repaid over a specified period, usually with interest.

Types of Loans:

• Personal Loans: Used for a variety of purposes, such as debt consolidation, home improvements, or unexpected expenses.
• Mortgages: Loans specifically for purchasing property. These are typically secured against the property itself.
• Business Loans: Used by businesses to finance investment, expansion, or working capital. These can be secured or unsecured.
• Car Loans: Loans specifically for purchasing a vehicle. These are typically secured against the vehicle.

How Loans Work:

1. Borrower applies for a loan, providing details about their financial situation and the intended use of the funds.
2. The bank assesses the borrower's creditworthiness, considering factors like income, employment history, and credit score.
3. If approved, the bank specifies the loan amount, interest rate, and repayment schedule.
4. The borrower receives the loan amount.
5. The borrower makes regular repayments (usually monthly) over the agreed-upon period, including interest.

Cost of Loans:

The cost of a loan is determined by the interest rate. Interest rates can be fixed (remain the same throughout the loan term) or variable (fluctuate with market interest rates).

Factors Influencing Loan Interest Rates:

• Credit Score: A higher credit score indicates a lower risk to the lender, resulting in a lower interest rate.
• Loan Amount: Larger loan amounts may attract lower interest rates.
• Loan Term: Longer loan terms typically result in higher overall interest payments, although monthly repayments are lower.
• Economic Conditions: Overall interest rates in the economy influence loan rates. Central bank policy plays a key role.
• Risk Profile of the Borrower: Factors like employment stability and income are considered.

Table: Comparison of Overdrafts and Loans

Feature	Overdraft	Loan
Purpose	Short-term cash flow management	Longer-term financing
Interest Rate	Typically high	Variable (can be fixed or variable)
Repayment Schedule	Flexible, often no fixed schedule	Fixed repayment schedule (e.g., monthly)
Security	Usually unsecured	Can be secured or unsecured
Eligibility	Requires a good credit history	Requires a good credit history

Credit Scoring:

Credit scoring is a process used by banks and other lenders to assess the creditworthiness of borrowers. It involves analyzing a person's credit history, including past borrowing and repayment behavior. A higher credit score indicates a lower risk of default and typically results in more favorable loan terms.

The role of the Credit Reference Agencies (CRAs):

CRAs collect and store information about individuals' credit history. This information is then used to generate a credit score. Examples of CRAs include Experian, Equifax, and TransUnion.

Impact of Lending on the Economy:

Lending plays a crucial role in economic growth. It allows individuals and businesses to invest in capital goods, expand operations, and consume goods and services. However, excessive lending can lead to asset bubbles and financial instability. Central banks use monetary policy (e.g., adjusting interest rates) to manage the level of lending in the economy.