A small business needs finance for a variety of reasons. To satisfy such needs, a commercial bank disburses different types of business loans. The commercial banks distributes these loans depending upon the:
- growth stage and
- nature of your business
Now, each loan type has its own qualification requirements, rate of interest and term of lending. Furthermore, each type of business loan caters to specific business needs. This helps businesses plan disbursements accordingly.
Therefore, there are five types of loans broadly:
- Term Loans
- Line of Credit
- Equipment Loans
- Bank Overdraft
- Working Capital Loan
1. Term Loans
Term loans are secured loans offered to a business for its expansion, capital expenditure and for fixed assets. As the name suggests, these loans are provided in lump sum for a specific period of time and must be repaid in regular installments. The duration for repaying such loans usually extends to a long period ranging between 5 to 10 years. Furthermore, the rate of interest charged for these loans may be a fixed or floating rate. Such an interest rate depends upon the credit risk, loan amount and the tenure of the loan.
There are a host of banks and NBFCs that offer term loans at different interest rates and processing fees. For instance, HDFC Bank offers term loan at the rate of 15.65% with a processing fee ranging between 0.99% to 2.50%. Similarly, ICICI Bank offers business loan at the rate of 16.49% with a processing fee between 0.99% to 2%.
2. Line of Credit
Line of credit is basically an agreement between a financial institution and the borrower. Accordingly, the lender agrees to lend a maximum amount of money to the borrower depending upon his credit worthiness. Under this facility, the borrower can withdraw money as and when there is a need. However, such a withdrawal cannot exceed the maximum limit disbursed.
Accordingly, the interest is charged only on the amount borrowed and the amount that stands non-utilized does not carry any interest. What makes line of credit different from a business loan is that it offers a set amount of money that the borrower can use whenever he needs the same. That is, he has the flexibility to take out money, pay it back and repeat the process unless he sticks to the terms. Provided he can borrow to the extent of the maximum amount or limit that is set.
3. Equipment Loans
To carry out business operations, every business needs finance to upgrade existing machinery or invest in new equipment. Purchasing equipment outrightly puts strain on the business cash flows. Hence, to avoid such a scenario, equipment financing comes handy.
Equipment financing refers to a loan used to purchase business-related equipment including computers, machinery, vehicles etc. Under such an arrangement, the borrower is required to provide periodic payments that include interest and principal over a fixed term. Furthermore, to secure the loan, the lender demands a lien on the equipment so financed as the collateral against your loan. Once you pay the loan in full, you own the equipment free of any lien.
The rate of interest charged on such loans is fixed and usually varies between 8% to 30%.This rate depends upon the value of the equipment to be financed, your business’ financial history and your credit score.And the time period for which such a loan is disbursed is usually for 1 to 5 years.
4. Bank Overdraft
Bank credit is contemplated as a short-term credit that is provided by a financial institution to a borrower. This facility involves extending credit to a borrower when there are insufficient funds. That is, when the account reaches zero. Simply put, a bank overdraft facility allows customers to borrow a set amount of money on one’s own account.
The bank lends money to the borrower under such a facility based on the borrower’s:
- account value
- credit score and
- repayment behavior
Furthermore, the overdraft facility levies interest on the amount used over a given time period. This means the interest is not charged on the amount that remains non-utilized over the given time period. Furthermore, bank determines the time period allowed to the borrower for using the credit amount. Such time period ranges from a couple of days to a few weeks.
Bank Overdraft facility helps in dealing with the cash flow challenges that a business encounters on day-to-day basis. There are times when customers make a delay in giving payments and consequently there is no option but to wait. However, it would not be so in case of bank overdraft facility attached to a current account. Such an arrangement gives the leeway to sign cheques for customers even if there are insufficient funds in the account. This prevents cheque dishonour and maintains the reputations of the business as well.
To avail this facility, a business has to pay a certain amount of annual fee to the bank. Moreover, the business has a right to discontinue the service whenever it wants.
4. Working Capital Loan
Working Capital Loan is a short term loan that helps in financing the day-to-day operations of your business. Such operations can include managing payroll, paying rent, purchasing inventory, procuring raw material, maintaining cash etc.These loans aren’t used for making long term investments owing to shorter term periods and lower loan amounts.
Working capital loans are used by companies that do not have stable or predictable stream of revenue during the year. The best case in point here is that of a manufacturing company. The sales of a manufacturing company are cyclical in nature. Such a seasonality is the result of the sales being dependent upon the requirements of the retailers. Since retailer sells most of his products during holiday season, the manufacturer produces goods during the off season itself. Then, when the holiday season comes, the manufacturer stops making purchases and sells the inventory.
Therefore, a manufacturer needs working capital loan to meet operating expenses during the time of the year when there are no sales.
Thus, bank gives working capital loans to a borrower for time period ranging between 6 to 12 months. Furthermore, the rate of interest levied on such loans ranges between 11% to 16%.
The following infographic lists the type of business loans that an entity can undertake from banks.