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written by | September 2, 2022

Definitions and Variations of Loans and Advances

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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.

Also read: Inventory Control - What is Inventory Control, Why it is Important & More

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

Also read: Inventory Turnover Ratio - Definition, Formula, Examples & More

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.

Also read: Cost Accounting - What is Cost Accounting, Types & More!

  • 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.

Basis For Comparison

Loans

Advances

Meaning

The term loan refers to money borrowed by one entity from another, repayable after a defined period and carrying an interest rate.

In advance, a bank provides funds to an entity for a specific purpose, and the funds are repaid over a short period.

What is it?

Debt

Credit Facility

Term

Long Term

Short Term

Legal formalities

More

Less

Security

May or may not be secured

Primary security, collateral security and guarantees.

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.

Also read: Goodwill in Accounting - Learn About Types of Goodwill and How to Calculate Goodwill

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.

Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: How are loans and advances recorded in the organisation's balance sheet?

Ans:

Loans and advances undertaken are recorded on the liabilities side of an organisation’s balance sheet as it must repay the amount. It can further be recorded under long-term or short-term, based on the nature of the loan or advance taken.

Q: Are there any loans that an individual can take?

Ans:

Yes. Individuals can take various loans to meet their requirements, such as personal loans, home loans, two-wheeler loans, gold loans, education loans etc.

Q: What are the various types of loans and advances?

Ans:

There are different types of loans and advances offered by financial institutions for other purposes. You should select the one based on your needs, the risk you are willing to undertake, or even the guarantee you can provide.

Q: What are loans and advances?

Ans:

Loans and advances are sources of finance that can be used to meet our business’s short-term or long-term funding requirements. Loans are suitable to meet capital requirements, while advances are ideal for meeting the daily needs of the business.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.