Business Loans Vs Overdraft Which Is the Better Option

There are overlaps between business loans and overdrafts, but there are a lot of uncommon aspects too. Although they may be used for the same purposes, they are created for different reasons.

Borrowing money in the form of business loan or overdraft is a normal process. Businesses rely on short- and long-term capital to fuel their growth. Without good debt, it is not possible to extend the capabilities of a business in short time to meet immediate demands. Market fluctuations and dynamics require the use of debt as an instrument to build products and services in time. So that opportunity to sell them at a good profit does not go wanting.

But there has always been a debate or confusion over a business loan and overdraft. There are overlaps between the two, but there are a lot of uncommon aspects too. Although they may be used for the same purposes, they are created for different reasons.

What is a business loan?

Business loans can be secured or unsecured loans. They can be availed from banks and non-banking financial corporations. Various digital lending agencies, crowdsourcing companies, lending institutions have business loans schemes as well.

Secured business loan

A secured business loan is one that needs collateral as security. This form of security ensures a level of predictability and stability for the lender. The lender is assured that even in the event of non-payment of the loan; the collateral will provide the means of recovering the debt. Collateral can be a combination of property, shares, money market instruments, bank deposits, gold etc. Secured business loans are generally of larger amounts. For smaller business loans, banks may not necessarily ask for collateral. But this again depends on criteria such as the borrower’s profile, spending habits, credit history etc.

Unsecured business loan

An unsecured business loan is of generally smaller amounts. But this is not true in all cases. Certain banks do give large unsecured business loans to large conglomerates, businesses, multinational companies, industries etc. based on their relationship with the banks. If a business has a good track record with a bank, and if the business wants a large business loan, the bank can grant this loan without the need for collateral. It solely depends on the banks existing policies, which may vary as per the lending climate, the existing banking rules, the need for liquidity in the economy etc. An unsecured business loan does not require the borrower to provide any collateral as security.

Structured business loan

A structured business loan is one that is given in phases. It is generally of a large amount. As and when the business shows progress, the loan is given in portions. A structured business loan mitigates any risk at the outset for the bank. But giving the loan is phases the bank has visibility on the progress of the business. The bank can then decide to release the next portion of the business loan based on the progress report card furnished by the bank.

Unstructured business loan

A business loan that is given in whole and not in portion is an unstructured business loan. The bank fully trusts the business to carry out their expansion activities. Based on the discretion of the bank an unstructured business loan is given if the business needs all the money at the outset. This is especially true for certain business projects where it is not clear how much money would be required for each of the phases of the project.

What is an overdraft?

A business could maintain a current account with a bank. The current account is used for cash, online and cheque transactions. In a day, thousands of transactions could take place from the current account of this company. At times, there could be a shortage of funds. The company will have an overdraft facility that will ensure that even when there is a shortage of funds, the overdraft amount is available to be used. Therefore, overdraft money is a type of debt that is used as reserve money when the main funds are not sufficient. Overdraft funds are only charged interest for the portion of money that was borrowed. This aspect is a huge difference between overdraft and business loan.

There are different types of overdrafts:

Authorized

With such an overdraft facility, the business makes an arrangement with the bank in advance. The bank and the business agree to a benchmark overdraft limit. For businesses and individuals like, the rate of interest is 15% to 20%. Considering that an overdraft is pricier than a business loan, discretion should be used when using it.

Unauthorized

In this type of overdraft facility, there is no prior agreement on the overdraft limit. But overdraft amounts withdrawn are charged with higher interest rates. Unauthorized overdrafts are not very common although they exist for certain type of business acquaintances between banks and companies.

Advances of overdraft facility

● Manage mismatch of cash

o Overdrafts are helpful when there is a payment due, and the business does not need to worry about a failed payment. Even when there are insufficient funds in the bank account, any extra money needed to repay a vendor or supplier can be retrieved from the overdraft amount.

● Preventing cheque bouncing

o Dishonored cheques are illegal and could put a business in legal risk. To prevent such situations, companies activate their overdraft facility. So that even when there is a shortage of funds, a cheque when presented to their bank account will pass through using the overdraft amount.

● Easy to manage

o Overdraft facilities or accounts are easy to manage. They require less paperwork and minimal documentation. Once activated, only the used portion of the overdraft loan is charged interest.

FAQs

1. What should I take a small or big business loan?

You can take business loan for business expansion, business growth, or to maintain business momentum.

2. What is line of credit in a business loan?

It is a pre-approved loan for business loan account holders with a bank or an NBFC like Lendingkart.

3. What is a term business loan?

A term business loan is a regular loan with a fixed repayment schedule constituting of EMIs.

4. Which has higher rate of interest? Business loan or overdraft?

An overdraft loan has higher rate of interest in general. Only in rare cases will business loans have high rates of interest.

5. What is the eligibility for availing overdraft on a personal account or business account?

Age criteria, personal or business income, repayment track record, credit score are all taken into consideration for the eligibility check.

6. Why is an overdraft loan applied high rate of interest?

An overdraft loan is a type of unsecured credit over and above the base eligible amount of the account holder. Unsecured credit has a higher rate of interest.

7. Can a business loan and overdraft facility be availed together?

Yes. But typically, it is done using different account. The same loan account is not used for an overdraft facility. 

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