Line of credit vs overdraft vs credit card: Which is right for you?

We’re all likely to need extra funds from time to time, to help with cash flow, carry out renovations or take a much-needed holiday. Banks offer a variety of ways you can access money, but they work differently and suit different financial situations – so you’ll want to give some thought to which one is the best bet for your specific needs.

A line of credit is often used for larger, drawn-out expenses; an overdraft can provide cash flow support in the short-term; while a credit card is commonly used for everyday spending and one-off purchases.

We’ve put together this guide to run through the potential pros and cons of each of these financial tools, to help you make an informed decision, manage costs, and avoid unnecessary debt.

Key take-outs

• A line of credit acts like a loan for an agreed amount, but you only use as much of it as you want to and can dip into it whenever you need to.
• An overdraft is linked to a bank account and is a pre-agreed amount you can access if your balance drops below zero.
• A credit card gives you the convenience to make purchases now and pay for them later. 

What is a line of credit?

A line of credit is a flexible loan, which is why Westpac calls it a ‘Flexi Loan’. When you apply for one, you agree to a predetermined credit limit – but can use the funds gradually as and when you need them, rather than receiving a lump sum upfront.

Think taking a holiday, where you only need enough for the flights initially, then later the accommodation, followed by the spending money.

The key feature of a line of credit is that you only pay interest on what you’ve drawn down. Then once you’ve paid off your loan, you can access it again whenever you want to without reapplying.

Key benefits of a line of credit

• Flexibility
  You choose when to access funds up to the agreed limit and can do so for as long as the line of credit is active – and your repayments can be flexible
• Only pay interest on what you’ve used
  This avoids you paying interest on loan funds sitting unused in your bank account.
• Suits ongoing expenses
  A line of credit may work well for situations where you need gradual access to funds, such as for renovations or ongoing medical expenses.

Potential drawbacks of a line of credit

• Variable rates
  Most lines of credit have variable interest rates, so you may have to factor in an increase in repayments should rates rise.
• Risk of ongoing debt
  If access to funds is too convenient, you may be tempted to dip into them more than you really need to.
• Risk to property if used as security
  If your line of credit is secured by your property (Westpac Flexi Loans aren’t), your home could be at risk if minimum monthly repayments are not maintained.
• Fees may apply
  Some lenders (including Westpac) charge establishment fees, account-keeping fees and other fees – so it’s a good idea to compare these before committing to a line of credit.

What is an overdraft?

An overdraft is a way of borrowing money that allows you to spend more than you have available in your transaction bank account, up to an approved limit.

For example, if you have $50 in your account and a $500 overdraft, and need to pay $300 for a car repair, your balance will become -$250. You’ll be charged interest on only the amount ‘borrowed’ ($250), not on the $500 you have available, until your account balance reaches zero or more.

Or, if you have insufficient funds in your account to cover a direct debit, an overdraft can help the payment go through while you work to get back into credit.

Key benefits of overdrafts

• Immediate access to funds
  As your overdraft is linked to an everyday account, you’ll be able to access it as you do other transactions – such as through a debit card or ATM.
• Handy for plugging short-term cash flow gaps
  An overdraft can be a useful safety net to help tide you over until your next payday.
• Only pay interest on what you’ve used
  Interest is usually charged only on the overdrawn balance.
• Pay off your overdraft at your own pace
  Every deposit into your account will reduce your overdraft balance and the interest you pay.

Potential drawbacks of overdrafts

• Higher interest rates
  Overdrafts are generally unsecured, so rates can be relatively high when compared to secured loans, such as car loans, where your asset is used as security.
• Overdraft fees and charges
  Some lenders (not Westpac) may charge an establishment fee to set up an overdraft facility, and you should compare account-keeping and other fees too.
• May not be a long-term solution
  Overdrafts are generally designed to help manage cash flow in the short term.
• Risk of becoming dependent
  What may be set up to help with temporary borrowing, can become a loan that’s over-relied upon – potentially leading to ongoing debt.

What is a credit card?

A credit card is a flexible source of credit you can use to buy things up to an approved limit. As you reduce the balance by making repayments, the available credit can be used again for purchases – and if you pay off your balance in full each month you can avoid paying interest.

Credit cards are widely used in Australia due to their convenience, interest-free periods, and reward programs (for selected reward credit cards).

Benefits of credit cards

• Convenience
  You can use credit cards across the world (though potentially with additional fees), in-store, online, and linked to mobile payment apps.
• Interest-free periods
  Credit card issuers generally offer between ‘up to 44’ and ‘up to 55’ days interest-free on purchases.
• Rewards
  With some credit cards you can earn frequent flyer points and other perks, including complimentary travel insurance.
• Emergency access to money
  If you’re faced with unexpected expenses such as a medical emergency overseas, a credit card may give you quick access to the immediate financial support you need.

Potential drawbacks of credit cards

• High interest rates
  When compared with other financing options, credit cards have some of the highest interest rates.

• Risk of overspending
  Having easy access to credit can encourage some people to indulge in unnecessary spending.

• Escalating debt
  It’s easy to allow credit card debt to grow, and repaying only the minimum each month can significantly increase the amount paid in interest over time.

• Fees may apply
  No or low annual fee credit cards are available, but reward cards have fees (including third party program fees) and all cards are likely to charge for late payments and cash advances.

Line of credit, overdraft or credit card. Which to use and when?

Different types of loan suit different scenarios. It’s important to do your own research, compare the features and fees of different lenders, and go with the option you feel most comfortable with. In summary:

A line of credit is typically used when:

• You need ongoing access to larger amounts
• You want to pay for a project or personal need that has staggered expenses
• You’re an investor with irregular expenses
• You want more flexibility without having multiple loans.

An overdraft is typically used when:

• You need short-term support for your domestic cash flow
• Your income is irregular – it may fluctuate with seasonal or other factors
• You have the occasional need for emergency funds, such as medical.

A credit card is typically used when:

• You want convenient access to credit for your everyday expenses
• You’re able to repay your balance each month
• You’re a frequent traveller
• You need access to emergency funds
• You want points, rewards and other perks.

Alternatively, if you’re aiming to make a larger, one-off purchase, it may be worth considering a traditional loan instead of the above.

What if I have business needs?

If you’re in business including as a sole trader,  you may wish to consider a Business Overdraft linked to your Business Transaction Account to support your business cash flow and working capital to help maintain smooth operations. Or apply for a business line of credit or a Business Loan, or use Business Credit Cards.

In summary

Lines of credit, overdrafts and credit cards can all provide access to funds, but each suits different needs. Therefore, it’s a good idea to not only compare them feature by feature when deciding what’s best for your particular circumstances, but be sure to compare interest rates, fees and repayment terms of the lenders you’re considering too.