Banks or NBFC: Which is better for Business Loan?

Bank or NBFC for Business Loan Overview

As a business owner, your reliance on loans from banks is quite understood as the business goes through several ups and downs. There would be very few businesses which can withstand unpredictable business cycles and manage headwinds without worrying about any business loan. For those who are unable to scale up because of crunch in the capital always turn to loan from banks. Today markets have opened up and the government has also supported SMEs through various schemes and loans. There are a plethora of options available if you want to apply for a business loan. Of all the choices available you usually get stuck between a bank and NBFC. Here we demystify both the financial institutions which can help you make an informed decision for your business.

It is important to have clarity on the two financial intermediaries in any financial system. NBFC is primarily Non-Banking Finance Company that provides banking services without holding a banking license or any legal agreement. NBFCs have to get registered under the Companies Act 1956 to offer services similar to banks. NBFCs are privately owned institutions regulated by the RBI and other government entities.

While a bank is a financial institution that accepts deposits from the public and creates credit. Banks can perform lending activities either directly or indirectly through capital markets.

Banks can manage financial services and products generally authorized to them. Most importantly banks can accept demand deposits while NBFCs can only lend or invest but they are not allowed to accept demand deposits.  A demand deposit is a bank account which allows the account holder to withdraw his money from the account at his will and by any means without notice to the bank.

The functions of NBFCs are limited to the extent that they can accept/renew public deposits for a minimum period of 1 year to 5 years. The maximum interest rate an NBFC can offer is 12.5%. Also, keep in mind that the RBI doesn’t guarantee the repayment of deposits by NBFCs, unlike banks. Since NBFCs doesn’t form a part of the payment and settlement system, it cannot issue a cheque to its customers.

In fact, both institutions offer attractive deals to customers with different needs of borrowings. NBFCs are typically divided into three categories –Asset, Loan and Investment Companies.

In recent times Indian banks’ are struggling with bad loans which has given way to NBFCs which are not as strictly regulated as banks. Access to formal credit is still a big challenge to MSMEs, with nearly 40% of lending taking place through informal sources, according to report by the Omidyar Network and BCG. To avail a small business loan, NBFCs can offer a better deal than traditional banks. Here are some of the reasons.

Interest rates

Bank loans are typically linked to the MCLR, the minimum interest rate below which a bank is not permitted to lend. It is further linked to macro-economic factors such as RBI lending rates, international market, etc. On the other hand, NBFCs offer loans  based on the prime lending rate (PLR) which is not regulated by RBI.  As a result, NBFCs can exercise some amount of freedom to increase or decrease loan rates as per their requirements. It benefits the customers and offers them multiple options, especially when they can’t meet the loan eligibility criteria of banks.  NBFCs get an edge over banks who can’t lend below MCLR slab. It is seen that cases, where owners easily meet the criteria may end up paying higher interest rates compared to a loan from banks.

Loan eligibility

The eligibility of a loan can differ between a bank and NBFC. Since it is not regulated as tightly as banks, NBFCs can sanction amount higher than banks. Also, most banks don’t fund the entire credit requirement and fund only a certain portion and the rest has to be paid by the borrower. However, NBFCs can find out ways to help borrowers and sanction the entire business loan. While some NBFCs offer business loans with a loan limit that is pre-approved, which means if you are a business owner you can withdraw funds from your pre-approved loan limit. The most interesting factor is that businesses will be paying interest only on the used amount and not on the entire loan amount, unlike the term loans, where EMIs are on the entire amount. The interest is charged only on the amount utilized which can help in reducing the monthly business loan EMIs. Such pre-approved loan limit comes to the rescue of business and ensures they are never devoid of capital. Moreover, there is no need to apply for multiple applications for procuring loan at any point in time.

Paperwork

NBFCs have a good share of small business loans in their books because of the above reasons. Most people turn towards business loan from NBFCs because of less documentation and paperwork while banks can be stringent when it comes to approval of the documents. If you are unable to provide requisite documents, banks may not process the loan and refuse the application. However, NBFCs have minimum documentation and the business loans are processed much faster than a bank.

Credit Score

Banks follow strict guidelines and ensure that the borrower has a good credit score because business with a poor credit score is deemed risky. NBFCs may offer and accept SME business loan even if the credit score is not too good. However, keep in mind in such a scenario you may have to pay a higher interest rate to balance out the default risk. As the capital need is of prime importance for small business it is imperative that you evaluate all the options available. In 2017, the Reserve Bank of India in its financial stability report found that the NBFCs are more successful than banks and their balance sheet expanded 15.5%.

Both lending institutions have their pros and cons. As a business owner, you should carefully read the offer documents, calculate EMIs with the help of business loan calculator and consider the benefits mentioned above before approaching to either of the two for a small business loan.