If you are an entrepreneur and want to start a new business or expand your existing business, you may consider taking out a business loan or overdraft for your financial needs. These two financial products provide the borrower with funding support, but they differ in their natures and features.
Choosing the right credit facility depends entirely on your financial needs. Let us discuss some of the basic features and comparisons of these two credit facilities so that you can make an informed choice.
Let’s start with the basics first.
What is a business loan?
A business loan is a type of loan specifically designed for businesses to help them finance various aspects of their operations. It can be used for a variety of business purposes, like expanding a business, obtaining working capital, purchasing land, buying machinery, hiring staff, training employees, purchasing raw materials, and increasing stock and inventory.
A business loan is generally regarded as an unsecured loan, although some business loans can be secured with collateral.
Example of Business Loan
Let's say you own a bakery and want to open a new branch in a different location. However, you need funds to lease a space, purchase baking equipment, hire staff, and market your new bakery. Instead of relying solely on your personal savings or profits from the existing bakery, you can approach a bank or a lending institution to apply for a business loan.
With the loan amount, you can lease a suitable space, buy ovens, refrigerators, display cases, and other necessary equipment You can also use some of the funds to pay for initial marketing expenses and hire and train new employees. As your new bakery starts operating and generates revenue, you use the income to repay the loan over the agreed-upon period, typically with interest.
Who can apply for a business loan?
A variety of entities, such as individuals, women entrepreneurs, retailers, manufacturers, traders, private and public limited companies, sole proprietorships, partnership firms, limited liability partnerships (LLPs), NGOs, SMEs, MSMEs, and large companies can apply for a business loan. It is possible to avail of credit facilities that best suit a customer's needs with minimal documentation and a hassle-free process.
What is an overdraft?
An overdraft is a financial service offered by banks that allows an individual or business to withdraw more money from their bank account than they currently have available. It essentially allows the account holder to have a negative balance, up to a predetermined limit, for a short period of time. Overdraft fees and interest rates differ between financial institutions. An overdraft can be used for any business purpose and can be accessed at any time, making it a convenient funding option for unexpected expenses or opportunities that arise unexpectedly.
Applicants must submit a written request to their respective banks to avail of an overdraft facility. The renewal of the credit facility, which lasts one year, is subject to the bank's sole discretion. In a bank overdraft, the borrower deposits money to re-borrow it, with the interest rate charged by the bank depending on the debit balance of his or her current account.
According to RBI regulations, current account holders and cash credit account holders can apply for an overdraft of Rs. 50,000 per week. To avail of an overdraft facility, you need to have a decent financial history and maintain regular repayment habits with a good credit score.
Example of Overdraft
Suppose you have a personal bank account with an overdraft facility of Rs 500000. Your account balance is currently at Rs 100000, but you need to make a purchase of Rs 300000. Without enough funds in your account, you can utilise your overdraft to complete the transaction.
By using your overdraft, your account balance will temporarily show –Rs 200000 (Rs 100000 – Rs 300000). This means you have exceeded the available funds in your account, but the bank allows it up to the agreed overdraft limit of Rs 500000.
In this scenario, you will now have a negative balance of Rs 200000, including the overdraft amount. However, it's important to note that the bank will charge you interest on the borrowed amount until you repay it. The interest rate and fees associated with an overdraft can vary depending on the bank and the terms of your account.
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Business loan and overdraft: a comparative view
Here is an overview of how a business loan compares with an overdraft facility:
Is a bank loan a good option?
A business loan can be a good option if you want to take a larger loan amount for a longer period. Most banks and non-profit organizations offer fixed rates of interest on the loan amount, so you know how much to repay. A bank loan can be a viable financing option for businesses in India. But, it's essential to carefully evaluate the terms, consider alternative options, and assess the business's financial capacity to repay the loan. Certain advantages of business loans for businesses are mentioned below-
- Capital for business growth: Bank loans provide businesses with access to the capital they need to expand operations, invest in new projects, purchase assets, or launch new products or services. Loans can fuel growth and help businesses seize opportunities that would otherwise be unattainable due to a lack of funds.
- Flexible repayment options: Bank loans often come with flexible repayment options, allowing businesses to choose a repayment period that aligns with their cash flow and financial capabilities. This flexibility enables businesses to manage their repayment obligations more effectively.
- Diversification of capital sources: By securing a bank loan, businesses can diversify their sources of capital beyond their own internal funds or equity investments. This can reduce reliance on a single funding source and provide a more stable financial structure for the business.
- Building credit history: Timely repayment of bank loans helps businesses establish a positive credit history. A good credit history can enhance the business's credibility and improve its future access to credit on favourable terms. It can also help in obtaining larger loan amounts or better interest rates in subsequent loan applications.
- Lower interest rates: Bank loans often offer lower interest rates compared to alternative financing options, such as borrowing from non-banking sources or utilizing credit cards. This can result in cost savings and make the loan more affordable for businesses.
What are the benefits of Overdraft?
The Overdraft facility offers several benefits for businesses in India. Here are some of the advantages of utilizing an overdraft facility:
- Flexible cash flow management: Overdrafts provide businesses with flexibility in managing their cash flow. It allows them to withdraw funds from their bank account even when the balance is insufficient. This can help bridge temporary gaps in cash flow, cover unexpected expenses, or take advantage of immediate business opportunities.
- Pay Interest only on utilized amount: With an overdraft, businesses are typically charged interest only on the amount they actually utilize, not on the entire approved limit. This can result in cost savings compared to a term loan where interest is charged on the entire loan amount, regardless of utilization.
- Quick and convenient access to funds: Once an overdraft facility is approved, businesses can access funds quickly and conveniently. They can make withdrawals as needed, up to the approved limit, without the need for additional loan applications or approval processes.
- No fixed repayment schedule: Unlike term loans that have fixed repayment schedules, overdrafts do not have specific repayment dates. The business can repay the amount as and when it has surplus funds available, thereby providing greater flexibility in managing repayments.
- Overdraft as a cash cushion: Businesses can use overdraft facilities as a cash cushion for emergencies or unforeseen events. It serves as a contingency fund that can be accessed when needed, providing a sense of financial security.
Business loans and overdrafts both offer great financial solutions for growing enterprises, although each has its own advantages and disadvantages. A business loan provides a more secure source of finance with fixed repayment terms, but an overdraft gives you access to funds right away when you need them most. Ultimately, the one that offers your business more flexibility will depend on your needs and objectives.
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