Definitions and Variations of Loans and Advances

Finance is critical for any business. Money is required to meet any requirement related to production, sales, marketing, or day-to-day expenses. Businesses need money for investment and costs to be sustainable in the future. Proprietors or partners cannot invest money from their funds, therefore loans and advances enter the picture.

This article will assist you in providing a guide on the various types of loans and advances, the difference between loans and advances, and other information that will help you understand the topic.

Did you know?  You can get a business loan for 60 months at an interest rate of as low as 9.25% per annum.

What is a Loan?

A loan is a sum of money borrowed from a bank or financial institution by a business or individual with the obligation to repay it after a set period. As per Wikipedia, “In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc.”

Loans are typically used to meet an organisation's long-term commitments, such as capital requirements, building construction, machinery purchases, etc. The borrower must submit any asset of nearly equal or greater value than the loan amount, and such security is known as collateral.

The borrower must repay the lender all the money plus interest at the end of the specified period. The interest rate is usually mentioned in the sanction letter, which contains the loan's terms and conditions and is signed by both the lender and the borrower.

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What is an Advance?

An advance is a type of loan typically used by businesses to meet their short-term funding needs. It is generally expected to be repaid in less than a year, according to the terms and conditions of the Reserve Bank of India and the sanctioning authority, i.e., the bank. Advances can be made based on primary security, collateral security, or personal guarantees from directors, promoters, or partners.

What are the various types of loans and advances?

Now that we have learnt about loans and advances let’s learn about their types. There are various types of loans and advances, such as the following -

Types of loans

• Secured and Unsecured loans

Secured loans are the most common type of loan chosen by borrowers. Securities secure this loan, and the borrower must retain any of his assets as collateral security. If repayment is not made, the bank recovers the money by selling the security in the market.

Unsecured loans, on the other hand, are not secured by any kind of collateral. Banks are very thorough in checking the borrower's financial situation to ensure that there will be no default in repayment. Credit card purchases and education loans are two common examples of unsecured loans, with the student required to repay the money only after completing his studies and finding employment.

• Demand loan

A demand loan is a loan in which the lender can ask the borrower to repay the loan in full at any time and the borrower cannot deny it. This is already decided by both the parties in the terms and conditions.

• Term loans

Term loans are the ones with a set repayment schedule decided at the onset of the loan and are to be repaid only at the expiry of the said term.

• Purpose-driven loans

Nowadays, there are loans for almost every purpose, making things easier. Some of these loans are:

• Car loan
• Education loan
• Small business loans
• Two-wheeler loan
• Agriculture loan
• Gold loan

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Types of Advances

There are different forms of bank advances like

• Cash Credit

Organisations generally take a cash credit facility to meet their working capital requirements. It allows withdrawing money or issuing cheques up to the approved cash credit limit of the account.

• Overdraft facility

The overdraft facility provided by banks allows borrowers to withdraw more money than available in their account, but only up to a specified limit.

Difference Between Loans and Advances 

The concept of loans and advances may seem similar at first glance and some people may find it confusing. However, both of them have numerous differences, some of which are listed below. Some of the major differences between loans and advances are:

• Formalities Undertaken

The major difference between loans and advances is in the formality and the paperwork that the lender and the borrower have to go through.

• Loans- Since loans are a bit more formal, the paperwork involved while granting a loan is more. The pre-sanctioning process is very tedious as the lender has to do a thorough checking of the borrower’s financial status and purpose of taking the loan. For example, in the case of a home loan, the bank officials have to do a physical verification for the home for which the loan is being taken. The loan can also be rejected if certain terms and conditions are not met by the borrower.
• Advances- Advances, on the other hand, are less formal as the loans are approved only when the borrower meets certain pre-defined conditions. The paperwork and screening process are also not as tedious as a loan.

• Amount involved

• Loans- Loans are typically taken out for larger sums, and certain loans have a downward cap that prevents them from being obtained below a certain amount. Loans are appropriate when starting a new business and need capital or when planning to invest in a new project that requires a large sum of money.
• Advances- Advances deal with smaller sums and are typically used to meet an organisation's day-to-day needs. Working capital, bills purchased, and other short-term needs can be met by taking out an advance.

• Securities required

• Loans- Loans are typically granted in exchange for collateral security, such as assets, land and buildings, plant and machinery. The deposit's value should equal the amount of the loan. In the event of a loan default, the lender may sell the security to recover the loan amount. The papers of ownership of the asset kept as security are thoroughly checked.
• Advances- The security requirements for obtaining an advance are not strict. As previously stated, you can get a loan against primary security, collateral security, or personal guarantees. Primary security consists of the hypothecation of stocks and debtors, whereas collateral security consists of the mortgage of any asset. Advances can also be made in exchange for personal guarantees from the organisation's directors, promoters, or partners. Any of these things can serve as security for an advance.

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• Period

• Loans- Loans are typically granted for a more extended period, such as five years or even 20 years. The loan repayment mode is specified in the sanction letter and can range from Equal Monthly Installments (EMI), periodic repayment, or lump sum repayment at the end of the term. The repayment schedule should be set up at the loan's outset, and payments should be made following it.
• Advances- Advances are for a shorter period and can be taken for any period ranging from three months to one year. Most advances are undertaken for a year, and the repayment schedule is usually a lump sum payment at the end of the term.

• Interest component

• Loans- Bank loans include an interest component that is added to the principal amount at the end of the term and must be repaid in addition to the principal. The interest rate is generally determined based on market rates, and interest is charged at the end of each specified period. Since loans have a longer duration, the risk is higher because the interest amount is higher.
• Advances- Interest is also included in advances. However, because it is a short-term investment, the risk is relatively low.

Loans vs Advances: Which one to choose?

The choice between loans and advances entirely depends on your business needs.

If you are starting a new business or planning to expand an old one and require capital, opting for a loan is the correct option. Loans are perfect if you want to invest in long-term sources such as plants and machinery or buildings.

Advances, on the other hand, are a suitable source of finance if you want to fulfil your daily requirements.

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Conclusion

So, that was everything you need to know about loans and advances, the various types of loans and advances and the difference between loans and advances. Now you can make an informed decision about the source of finance you should opt for based on your business’s needs and requirements.

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