Loans Vs Advances: Differences between Loans and Advances

Money is a crucial component for any commercial business due to its unique function of fulfilling the transactional and fund requirements in the short and long term. In this capital deficient business world, where there is a palpable lack of working capital for all businesses, it is not feasible for the business owner to make good all the investment money by himself or herself. The onerous responsibility of providing loans and advances to individuals and companies falls on the financial institutions and lenders. The sanction of loans and advances needs to be considered when entrepreneurs are planning to open a business.

Loans and Advances: Overview

A loan can be defined as a monetary amount that is offered by financial organizations for a specific period. On the other hand, advances are provided by banking institutions to companies business organizations Hindu undivided partnerships to meet the requirements of working capital also known as cash flows with a stipulated time period of one year.

•  Both loan amounts come with the payment of interest. The mode of payment of interest can either be inappropriate monthly installments or a single lump sum.
• Advances can be further divided into a demand loan which is payable within 3 years from the date of sanction and a term loan whose repayment starts after 3 years. Similarly, the interest payments on the advances need to be made within a span of one year.

Comparison Chart

In the financial universe, consumers are often confused between loans and advances. However, there are subtle technical and administrative differences in the components of loan and advances such as:

1. Loan Quantum:

The quantum of loans is the single most important differentiating factor which influences the financial capability of both individuals and companies. The quantum of loans in personal advances depends on the income streams of the borrower on a monthly or a periodical basis.

In the case of companies, the method of selecting the loan quantum is a tad complex. The financial statements of the cash projections are taken into account to form an objective viewpoint of the present and future profitability of the company.

2. Interest application

• Since credit disbursement is a form of business to the majority of public and private lenders, the interest rate determinations have to be done with great commercial sense, so as to ensure a mutually beneficial relationship between both lender and borrower.
• The interest rates applied on the credit instrument depend on the financial status of the borrower.
• The RBI guidelines mandate that there should be an element of transparency when deciding interest rates for different classes of borrowers. The main challenge is to ensure the uniform application of interest rates across different borrowers of the financial spectrum.

The interest rate is seen as a reward that is given to disciplined borrowers who have a good credit history, excellent income levels and have a sound understanding of the business principles of the company.

Let us look at the salient definitions and points of differences among loans and advances:

Definition of Loan

The quantum of money given by the lender to any borrower for a particular purpose like the below can be categorized as a loan.

• Meeting the capital requirements
• Purchase of infrastructure and electronic machinery
• Construction of building
•  Incidence of interior decorations

The monetary amounts are given by the lender to different borrowers for particular business purposes also come under special loan variants such as home and business loans. Some of the end fund uses are:

•  Design and construction of the building
•  Comprehensive capital requirements
•  Purchasing of latest infrastructure
•  Maintenance work done on machinery

The classification of loan takes place in the given below categories:

1. Security basis

 a) Secured loan

Seeking collateral has become one of the important risk mitigation mechanisms for loan providers. Any loan that is advanced after taking the legal possession of a property in the form of a building, stocks and physical infrastructure is called a secured loan.

 b) Unsecured loan

An unsecured loan is a huge step of faith that the lender places in the borrower’s ability to repay the loan. As the name suggests the loan is complete without security. Commercial lenders are excluded by the design of the financial product, not to ask for any collateral security. One of the popular examples of an unsecured loan is an instant personal loan that is being offered at competitive interest rates by many lending institutions.

 2. Repayment basis

Gold loans are known to nearly every Indian citizen. It is one of the most common forms of loans taken which comes under the category of a demand loan. Technically the loan should be repaid by the borrower whenever the lender demands it.

• The interesting factor on the demand loans is compounded at a predetermined time period. There is no necessity of making equated monthly installments on a demand loan.
• The demand loan is generally of a lower quantum and is disbursed with the ultimate objective of servicing the educational and entertainments needs of the consumers.

 3. Time loan

Those loans which need to be repaid in their entirety including the principal and accrued interest at a particular date in the future are called the time loan. Some examples of a time loan are infrastructural loans. In these Time loans, a specific moratorium period is set at the beginning and a mutually agreed date is set by which the borrower needs to make good the entire principal and interest amount.

4. EMI Loans

Equated monthly installment loans come under this category. This is one of the most ubiquitous types of credit instrument among the Indian economic cycle. The entire economic engine runs on the smooth functioning of installment loans. It is an ironclad contract in which the borrower agrees to make a specific amount of monthly payment which includes the weighted component of both the principal and the interest.

5. Basis of purpose

Loans and advances have a singular common objective. That is to fulfill the credit requirements of the consumers. The various purposes in the personal and professional lives of the borrower are considered to come to a decision regarding the loan sanction.

Economic activity depends on the amount of capital generated by entrepreneurs and individuals businesses to make their profits sustainable and at the same time envision a high-quality future by taking the help of credit. Some of the best examples of a loan or advanced categorized on the basis of purpose are:

•  Home loan
•  Educational loan
•  Commercial loan
•  Industrial loan
• Car loan

Definition of Advances

The characteristics of this type of loan differ in certain areas when compared to other credit variants. Generally advance is a technical term that is used to fulfilll the credit applications of big business concerns and small businesses.

Some salient point about Advances

• Any loan which does not serve the personal fund requirements of individuals can be construed as an advance.
• Generally, advances are given to fund the short-term business requirements which include a revolving cash credit system that is extended to entrepreneurs.
• An Advance contract stipulates that the loan should be repaid within a shorter time interval when compared to personal loans.
• It is a common consensus among financial lenders that the tenure of an advance should be kept at a maximum of one year.
•  Different forms of credit instruments such as cash credit bill purchase and overdraft are part of a short-term loan. Overdraft is particularly useful to meet short-term cash flow factor patients in businesses.
• The borrowing conditions for advances are strict due to the higher risk of financial loss in businesses.
•  RBI is the central authority that formulates lending conditions in advances. The general economic conditions have to be factored in while calculating the tenure and interest rate options.
• All credit given to small and medium industries and different welfare programs of the government come under advances.

The differences between advances and loans:

Application of procedures and business formalities

 A crucial differentiating point between loans and advances in the diverse administrative formalities and documentation procedures. To get to the fund disbursement stage, in the case of loans, individuals need to submit income proof and ID documents.

• The sanctioning of advance to a business organization is highly formal in nature. Both business organizations and individuals undergo a wide-ranging screening process that determines the eligibility of the borrower or institution and judges their capability to repay the loan on time.
• The procedures that are applied in advance disbursement are quite complicated in the sense that they are technical in nature.
•  Business finance delves deeply into the concept of advances by asking for collateral security and guarantees. It is an exhaustive umbrella that includes the deployment of bank staff to check the sustainability of the business form.

The procedural formalities during loan disbursement are highly customer-centric. However, advances entail a number of:

• Screening mechanisms
• Documentation requirements
• Fulfilling legal obligations
• Third-party auditors and governmental regulations

2. Loan Quantum involved in advances and loans

Unsecured business loans go up to a maximum of 50 lacs and can be given to both individuals and businesses. Business operations can immediately be started by purchasing inventory and meeting expenditures on research and development. Personal loans have a maximum cap at Rs 25 Lakhs and that amount can be used by the borrower to purchase a car, to buy a home, to education needs and for conducting a wedding.

3. Period of payment in loans and advances

The period of repayment is a crucial difference between loans and advances. Various loan products such as educational loans, home loans and personal loans are inclined to have longer repayment tenure. This is due to the nature of the credit needs. Since the repayment is done from individual incomes and with an objective to maintain family stability, the repayment tenure is extended to offer comfort to individuals.

•  Loans can have repayment periods between 5 years and 30 years depending on the type of loans such as a personal loans or home loans.
•  The payment can be serviced by equated monthly installments as agreed in the contractual loan agreement at the beginning of the application.

A smaller repayment period is a hallmark of advances. The rationale behind this is that advances are generally given to businesses with a high market capitalization. It is implied that repayment will be done out of the profits on an annual basis. Companies should not find it difficult to repay the loans in a quick time.

• Generally, advances have a repayment time period range between 3 months and 1 year.
• The defining characteristic of advances is the introduction of a customization clause between the lender and borrower.
• Different terms and conditions can be applied selectively depending upon the financial and professional status of the directors of the company.

4. Interest rate applied in advances and loans

The interest component is a crucial profit factor for financial institutions during loan disbursal. The borrowers are legally obligated to service the demands of interest payment along with the principal repayment.

It is a general consensus among government-run banks and commercial lenders that the interest should be proportionately distributed across the repayment period.

Interest calculation is done basically on the borrowed principal amount. The method of interest compounding: quarterly or annually depends upon the mutually agreed terms between the lender and the borrower.  A significant part of the interest component in advances is set aside to cover the risk management cost.

5. Furnishing of collateral security in advances and loans

The majority of the personal loan which belongs to the low quantum category do not require securities. In the case of advances, collateral security is mandatory as businesses are risk-prone.  Interest rates and collateral security in the case of personal loans are on the lower side when compared to advances.

Some financial lenders may not even ask for collateral security for advances in the following case:

•  When the customer is known to the bank and has provided many collateral securities in the previous loans with the bank or lender.
• When the customer has significant deposits in the bank which can cover the principal amount given to the borrower

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