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Looking for right kind of funding for your business can be confusing. With the different types of credit options available in the market today, it’s natural for you to wonder – What sort of funding do should you opt for?
Do you need a business loan or an overdraft facility? How about line of credit or invoice financing or cash flow loans? Or should you choose between long-term and short-term financing? How about borrowing funds with or without a collateral security (e.g., loans against property in business against unsecured business loans)?
The options are numerous, and the situation can be daunting for a first-time borrower, and even a seasoned borrower. In this article, we look at two of the most common financing options for small businesses – business loan and overdraft – and understand which is a better financing option.
What is a business loan?
Before you decide on whether to apply for a business loan or overdraft, let us understand the meaning of a business loan.
A business loan is a credit facility offered by banks and NBFCs for the purpose of running the business. It can be a secured or unsecured loan i.e., with or without collateral, working capital loans, commercial vehicle loan, or a loan taken to buy inventory, lease/rent property, buy machinery, pay salaries or any other business need.
What is an overdraft?
A bank overdraft is a credit facility that allows existing customers to borrow a small sum of money against their bank account, when the account balance is low or reaches zero.
Based on the borrower’s creditworthiness and relationship with the bank, the bank may extend to him/her a small credit option for meeting immediate business requirements. There are overdraft fees and charges involved, but it helps the borrow to solve immediate cash crunch challenges (even with zero balance).
Difference between business loan and overdraft
This brings us to our current discussion on which is a better option – bank overdraft or business loans? Let us take a look.
Amount borrowed: Overdraft vs business loans
What is the loan amount you are looking for? If you are looking for a high loan amount (e.g., ₹20 lakh+) consider seeking a business loan. An overdraft option is more feasible when you need a smaller amount for a short duration i.e., emergency funds.
Most banks and NBFCs offer small business loans to businesses. Depending on the lender, collateral-free loans are usually available for up to ₹1 crore (the amount can be more for certain lenders based on the borrower’s creditworthiness).
As a borrower, evaluate your purpose, the amount of loan you require and apply for the right type of business loan. Quick tips:
- Always ask for an amount that you need
- Check your existing resources, ongoing EMI and payments, to ensure you will be able to repay
- Ensure that you maintain the minimum credit score requirement (i.e., 650+) for seamless loan sanction
Collateral requirement: Business loans and bank overdraft
As stated previously, it is not mandatory to offer collaterals when availing a business loan. Though, lenders will ask for collateral for small business loans as it reduces their risks, there are several lenders who offer collateral-free, unsecured loans.
Overdraft facility naturally does not require any collateral. You need to maintain a current account and take an overdraft loan based on the prescribed limit.
Duration/term: Business loan vs overdraft
Do you need funds immediately or do you want to borrow for the long term? If you are looking to borrow for the short-term, consider taking an overdraft (considering you meet the eligibility). If you need funds for a longer period (e.g., 5 -10 years), consider a business loan.
Business loans can be availed as long-term loans based on the amount and purpose it is being borrowed for. For instance, if a sum of ₹50 lakh is being borrowed for 5 years for buying trucks, a business loan (i.e., commercial vehicle loan) is more suitable. The truck can be mortgaged as collateral, reducing the total loan interest rate and EMI. Once the loan is repaid, the borrower becomes the owner of the vehicle. In case the borrower is unable to repay the loan, the lender can liquidate it to recover losses.
Business loans can also be availed as short-term loans, when there is immediate requirement of funds.
Interest rate and EMI calculation: Overdraft loan and business loan
An important difference between a business loan and an overdraft facility is the interest rate charged. Business loans are offered at a specific interest rate. The loan interest rate varies between lenders and is determined by multiple factors such as borrower’s creditworthiness, loan amount, loan tenure, ongoing loans, business profitability, collateral offered etc. In general, business loan interest rate in India is usually within 10-22% (Note: Borrowers are advised to check the latest rates when borrowing).
In addition to the interest rate, the bank includes charges and fees (e.g., documentation fees, service charge, processing fee, etc.) and calculates the EMI or equated monthly instalments that the borrow needs to pay. For the best loan offers, it is recommended to negotiate a business loan before availing it.
The overdraft loan interest rate is calculated on a day-to-day basis. If eligible, banks authorise an overdraft limit to the borrower. The OD interest is calculated based on the amount availed from the sanctioned limit. It is debited from the existing account and affects the daily debit balance.
Note: Banks offer overdraft loan for salaried borrowers as well.
Eligibility criteria: Overdraft vs business loans
The next important different between a business loan and overdraft is in its eligibility. Who is eligible for a business loan? Who is eligible for an overdraft?
Business loan eligibility:
- Since a business loan is offered for business functions, you have to be a sole proprietor, OPC, director in an LLP, or similar to avail a loan
- The business should be running for a minimum of 2-3 years, and be able to provide bank statements, P/L sheets, utility bills, GST and ITR returns certificate, etc.
- Applicant must be of Indian nationality and within 21-65 years
- For availing start-up business loans (lender specific), additional details on credit score, personal bank statement, business plan etc. might be required
Note: Banks, NBFCs, and other lenders have specific loan eligibility requirements. It is recommended to check their website or speak with an official representative to know the exact requirements.
Bank overdraft loan eligibility criteria:
- Current account holders in banks (must be an existing business customer)
- Indian national between 21-65 years
- Current account must be active with KYC updated
- Cash flow, P/L statements, etc. for bank to determine the overdraft credit facility limit
Note: Overdraft facility is not provided by all banks/lenders. Please check with your bank if the facility is available. The right to not extend the overdraft option to customers is the discretion of the bank.
Overdraft loan or business loan – Which is better?
At this point the most obvious question on your mind is – Which is better? Business loan or an overdraft loan?
Here’s a quick comparison of the two financing options and their pros and cons to help you decide better:
Business loans vs bank overdraft: Comparison, advantages and disadvantage
|Purpose||Borrow funds to meet short and long term business needs e.g., expansion, working capital, purchase of machine/vehicle||Credit facility for emergency needs of the business|
|Tenure||Short and long term (i.e., usually 3-25 years)||Short-term immediate business needs (usually less than 1 year)|
|Eligibility||Business owners with 650+ credit score, 2 yrs+ business operations, P/L statements, and other KYC as per lender requirement||Must be an existing customer of the bank with an active current account|
|Loan amount||Low to high, up to ₹1-2 crore based on the lender||Overdraft limit assigned depending on borrower profile, account cash flow and balance, and lender discretion (usually up to ₹50,000/week)|
|Interest rate/EMI||Depends on lender, usually 10-22% for banks and NBFC, monthly EMIs calculated accordingly||Charged on a daily basis, on the amount utilised (usually higher than loans)|
To conclude, both business loans and overdraft credit facility have its pros and cons. If you want to borrow funds for immediate business requirements, an OD will work well. For long-term, planned business required, a business loan is beneficial. As a business owner, consider all these factors and choose what’s right for your business.