Organisations around the world function on the basis of funds and credit. Businesses must ensure that expenses for production materials, as well as administrative and operating costs, are met on time. However, funding is not just used for immediate needs; companies also require money to continue investing in their products or services to stay ahead of competitors.
People need money to meet various needs and ensure smooth operations. Since no business or person has a large supply of funds on demand, this funding gap can be bridged by loans and advances difference.
What is a loan?
A loan is a form of debt financing in which one party (the lender, who is generally a financial institution or a bank) lends money to another party (the borrower), who is then obligated to pay back the loan plus interest. The borrower may or may not be required to put up collateral when applying for a loan, depending on whether the loan is secured or unsecured.
The interest rate, fees, and repayment tenure of the loan can vary from one lender to the next and even from loan to loan. A loan can be used to pay for everything from a car to home renovation expenses to higher education to running a business.
What is an advance?
Advances are a form of funding that lenders give to businesses to cover their short-term needs. The central bank (RBI in India) and the institution lending the money make the decisions about the terms of the advances.
Types of advances
It is important to know the different types of advances to choose the right fit for you. The various kinds of advances include:
Short-term loan: The full amount is disbursed to the borrower at once in this type of loan. The loan tenure of payback is typically shorter, and hence this loan type is used by businesses to cover their operating expenses.
Overdraft: An overdraft is a bank service that lets a customer take out more money than they have in the account, up to a certain limit.
Bill purchase: Loans given by the bank in exchange for securing the bills/ invoices to be paid to you are known as bills purchase.
Cash credit: This is a feature offered by the bank that allows customers advance funds up to the value of a pledged asset.
What are the different types of loans and advances?
Read on to know the different types of loans and advances offered by financial institutions.
Types of loans
Different types of loans include secured and unsecured loans such as personal loans, mortgages, auto loans, student loans, and business loans. Personal loans cater to individual needs, student loans cover education costs, and business loans support entrepreneurial ventures. Each type serves specific financial requirements.
Secured Loans
Secured loans are loans backed by collateral, such as property or assets. If the borrower fails to repay, the lender has the right to seize the collateral to recover the loan amount. These loans typically offer lower interest rates because they are less risky for the lender. Examples include home loans and car loans.
Unsecured Loans
Unsecured loans do not require any collateral, making them riskier for lenders. As a result, they often come with higher interest rates. Lenders rely on the borrower’s creditworthiness and financial history to assess the risk. Personal loans and credit cards are common examples of unsecured loans.
It is important for the person taking out a loan or an advance to know how each one works and what the main pros and cons are. Therefore, you should be very selective in the organisation you choose to collaborate with on this venture.
Difference between loans and advances
Both individuals and businesses frequently use loans and advances as financial instruments to get funding. While both can be used to access money, loans and advances differ in several significant ways. These are four points of difference between loans and advances:
Loan amount:
When a corporation or an individual makes a loan application, it is usually for a considerable sum of money. This can be used to set up commercial operations, buy inventory, or put money into research & development. When people take out loans, for example, a personal loan, they usually use the money for expensive things like renovating their home, paying for higher education, or planning a wedding.
On the other hand, advances given to individuals or businesses are for much smaller amounts and are used to meet immediate or short-term financial goals.
Repayment duration:
Personal loans, car loans, education loans, and home loans all have longer repayment terms. A personal loan may have a maximum term of 8 years, whereas a home loan could have a maximum term of 30 years. Equated monthly instalments (EMIs) are the preferred method of repayment during the loan's specified tenure.
Advances have much shorter periods for paying them back, usually between 3 months and a year at most. The agreement between the lender and the borrower will determine the terms of repayment.
Interest rates:
Financial institutions charge interest on loans, which is added to the principal when the loan is paid back. The interest component is proportionately spread across the repayment tenure and is calculated based on the principal amount borrowed. The purpose of the fee is to cover the risk of approving the funds and the value of money over time.
Advances, on the other hand, are usually paid back in less than a year, and the interest is usually not very high. Hence, both the risk and the financial worth are substantially lower.
Collateral requirements:
Financial institutions may request a collateral deposit at the time of loan acceptance if the amount of the loan is substantial. This serves as a form of security that can be taken by the bank or NBFC if the borrower fails to make loan repayments for a specified period of time. Land, property, gold, fixed deposits, certain types of shares, and other items can be used as collateral.
When it comes to advances, you usually do not have to put up anything as security. Lenders may sometimes ask for a fixed deposit or a guarantee as the main security.
Loans and advances are two distinct forms of credit provided by financial institutions. While they both involve lending money, they differ significantly in terms of their purpose, processing, and associated formalities. Let’s explore the differences based on key aspects.
Usage flexibility
Loans are typically sanctioned for specific purposes, such as buying a home, financing a vehicle, or funding education. The borrower must use the funds as stipulated in the loan agreement. Advances, on the other hand, offer greater flexibility and are often extended for short-term needs, such as working capital for businesses or immediate financial requirements.
Documentation and approval
Loans involve extensive documentation and a thorough approval process. Borrowers need to submit proof of income, identity, and collateral (if applicable). Advances usually require less paperwork and have a faster approval process, as they are designed to address urgent financial needs.
Borrower eligibility
Eligibility for loans depends on various factors such as credit score, income level, employment status, and the borrower’s repayment capacity. Advances, however, are typically granted based on the borrower’s existing relationship with the lender, such as an active bank account or ongoing business transactions.
Purpose
Loans are structured for long-term financial goals, such as property purchase, higher education, or large-scale business expansion. Advances are meant for short-term needs, such as meeting day-to-day operational expenses or bridging temporary financial gaps.
Processing time
Loan processing usually takes longer due to detailed credit assessments and documentation requirements. It can range from a few days to weeks. Advances are processed much faster, often within 24-48 hours, given their short-term and urgent nature.
Risk
Loans carry a lower risk for the lender, especially when backed by collateral, but they involve higher stakes for the borrower due to the larger amounts and longer tenures. Advances are riskier for lenders as they are often unsecured and rely heavily on the borrower’s credibility and repayment history.
Legal formalities
Loans require comprehensive legal agreements that clearly define terms, conditions, and penalties. Advances involve minimal legal formalities, often relying on simpler agreements or promissory notes, given their short-term nature and smaller amounts.
Nature of transaction
Loans are formal and structured financial products with predefined terms for repayment, interest rates, and tenure. Advances are more informal and flexible, usually offered as an overdraft or credit facility that can be adjusted based on the borrower’s immediate requirements.
Understanding these differences helps borrowers choose the right form of credit based on their financial needs and circumstances.
Similarities Between Loans and Advances
While loans and advances serve different purposes, they share several similarities that make them essential financial tools:
- Financial Support: Both provide necessary funds to meet personal or business financial requirements.
- Repayment Obligation: Borrowers must repay the borrowed amount, often with interest, within an agreed timeframe.
- Documentation: Both transactions involve some level of documentation, though the extent varies.
- Creditworthiness Assessment: Lenders evaluate the borrower’s creditworthiness before disbursing funds.
- Interest Charges: Both loans and advances accrue interest, which is a primary source of revenue for the lender.
In essence, loans and advances function as key instruments to bridge financial gaps, enabling individuals and businesses to meet their objectives efficiently.
Loan vs Advance: Which One Is Better
The choice between a loan and an advance depends on your financial needs, urgency, and repayment capacity. Here's a comparison to help you decide:
- Purpose: Loans are better for long-term needs like buying a house, starting a business, or financing education. Advances are ideal for short-term, specific needs like salary advances or working capital.
- Amount: Loans usually offer larger amounts, while advances provide smaller sums for immediate requirements.
- Repayment Period: Loans come with longer repayment terms and structured EMIs. Advances are typically repaid in a shorter timeframe, often within months.
- Flexibility: Loans allow greater flexibility in usage, whereas advances are often tied to specific purposes.
- Processing Time: Advances are quicker to process compared to loans, which require detailed documentation and approval.
Evaluate your financial goals and repayment ability to choose the most suitable option.
Conclusion
Understanding the differences and similarities between loans and advances helps you make informed financial decisions. While loans cater to long-term goals, advances address immediate needs. Choose the option that aligns with your financial requirements, repayment capacity, and urgency for a seamless borrowing experience.
Bajaj Finserv Personal Loan could be the best option for all your personal loan needs. You can get a loan of up to Rs. 55 lakh with a flexible repayment period of up to 96 months. With the help of a personal loan EMI calculator, you can also figure out how much your monthly payments will be. This will help you make a good plan for your money and let you pay back the loan on time.
