Methods of Advancing Loans by Banks


There are four reliable methods of advancing bank loans. We know that "banks borrow to lend". After keeping a portion of the total deposits as cash reserve, the remaining amount is either invested or advanced to needy individuals and businessmen to earn profit. So for this purpose, the bank uses various methods to cash advance its balance. These methods are known methods of advancing loans from banks. Such loans are given to traders against certain specified securities. For a new customer, a loan account should be opened from which money is withdrawn by check but he pays the interest on the entire amount.

What is advancing loans?

An advanced term loan is similar to other types of term loans, but with a grace period where the business only pays interest.

Methods of Advancing Loans

Commercial banks use the following methods to advance loans to their customers:
  • Over draft
  • Cash credit
  • Fixed loans
  • Discounting bills of exchange

1. Over Draft

Through this method of loan advancement, the banker allows its reliable customers to withdraw over and above the amount actually deposited in their account. This facility is only allowed through check to current account holders, but only to those who have good financial and credit standing. These advances are given on the basis of personal securities. Civil officers and other salaried persons are also allowed an overdraft equal to six months' salary on condition of depositing their pay bills in the bank till the overdraft is recovered. Interest on overdraft is charged on the basis of daily debit balance on the actual amount drawn from the date. It is the easiest way to advance loans from banks, the bank earns profit and on the other hand, borrowers are given temporary benefits and are able to meet short-term requirements for money with the facility of overdraft.

2. Cash Credit

Another method of advancing loans is the cash credit method. With a cash credit arrangement, a customer is granted an advance up to a certain limit, which he can draw from time to time as per his requirement. In this method of advancing the loan, the bank pens a loan account in the name of the borrower and honors the checks drawn by him. In such loans, interest is charged on the amount actually used. If the funds are idle, the bank loses interest and some bankers make it mandatory to charge interest on some portion of the cash loan, whether the customer uses it or not. Cash credit is a short-term commercial loan, advanced to businessmen and industrialists against tangible securities. It is the most popular mode of borrowing by large commercial and industrial firms because of the convenience of drawing the amount whenever desired However, in this method of advancing the loan, the banker should take some precautions while advancing the loan. The banker must be satisfied with the honesty and credit standing of the customers. As John Pager says “Documents of title to goods are convenient security for advances if the banker is dealing with an honest and responsible person. Moreover, the banker should be familiar with the various markets and advances against salable products as security for the loan given.

3. Fixed Loans

Under this method of advance loan, the bank advances a fixed amount which is repayable in fixed monthly or yearly installments or in lump sum. It is usually borrowed to meet long-term requirements for capital. Interest is charged on the full amount of the loan sanctioned for the entire tenure, whether the borrower uses it or not. Such loans are given against security like gold ornaments, real estate, machinery, stocks and bonds. These securities are to cover the risk for repayment of the loan. However, some unsecured loans are offered to customers with good credit rankings. Different loans are advanced for different purposes and durations, which include consumer loans, industrial and commercial loans and agricultural loans for short, medium and long term.

4. Discounting Bills of Exchange

This is another way to advance customer loans. Banks discount bills of exchange held by traders, which are payable after a specified period. Banks repay the holder of the bill and pay an amount equal to their face value after deducting interest at the current market rate for the period the bill matures. By discounting bills of exchange, a bank accommodates its customer's short-term requirements for cash. Bills of exchange are very liquid assets to hold, as after their maturity, they can easily be converted into cash.

Principles of Advancing Loans

We also know that banks deal with other people's money, so before giving an advance to any banker, there are many factors to consider for proper investment and safe return of the principal amount with expected profit. These principles are as follows:

1. Principle of safety

This is the basic principle of using bank funds. There should be full safety and security of refunding the advance. For this purpose, banks require different types of guarantees and securities to cover the risk of advances. In case of loss, the advance amount is covered by selling the securities loaned.

2. Principle of liquidity

It is in the bank's interest to keep its money in liquid form, easily converted into cash at will. So the bank invests its money in short-term advances and avoids long-term financing like purchase of land, buildings and machinery.

3. Diversification in loans

While advancing the loan, the bank should satisfy itself about the purpose and use for which the loan is advanced. No advance should be granted for non-productive or illegal business.

4. Financial position

Before advancing any loan the banker must be satisfied about the character, financial condition and mode of repayment of the loan. Loans should be sanctioned according to the financial condition of the firm or industry. Beyond affordability, no loan should be granted, as there will be a greater risk in repayment.

In short we can summarize that advancing loans refers to the process of providing loan funds to a borrower ahead of schedule or before the due date. This type of loan is typically offered to individuals or businesses that need immediate access to funds and are willing to pay additional fees or interest for the privilege of receiving the loan early. The loan amount is usually advanced against a pre-approved limit and is repaid with interest over the agreed upon terms and conditions. Advancing loans can be a useful financial tool in emergency situations, but it is important to consider the cost and the impact on future loan payments before taking this type of loan.

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