Recent studies show that only 48% of small businesses have met their financing needs. Many might argue it is because of the lack of funding sources, but we believe it is majorly because of the lack of knowledge and understanding about the various funding sources available in the market. While tomes have been written about angel investors, venture capitalists, and series funding, not many are aware of the different types of business loans that one can avail of for their business needs. This blog post tries to bridge the knowledge gap and discusses 9 types of business loans in India today.
In India, there are various players that grant business finance to the public. Some of these are:
- Traditional banks
- Non-Banking Financial Corporations (NBFC)
- Government institutions
While the process of getting a business loan sounds daunting, there are some benefits to availing of business loans that cannot be missed. Some of them are:
Maintain working capital: Business loans help maintain a positive cash flow and manage the working capital for the business. These loans can help strengthen your financial stability during the off-season.
No equity dilution: When you avail of a loan, you don’t have to let go of a percentage of your business’s equity, unlike funds from VCs and angel investors. You do not share ownership with the lender.
Special benefits and concessions: Various lenders offer concessions and discounts on the interest you will have to repay. For example, some banks offer interest-free loans to budding women entrepreneurs. Some business loans even help you get tax benefits.
Business loans can be broadly classified into two categories:
- Secured loans
- Unsecured loans
Secured loans are the ones that are availed by pledging collateral, often property or business assets. Unsecured loans, on the other hand, are the ones that are availed without any collateral. You can read more about unsecured loans in our recent blog post.
Types of Business Loans in India
1. Term Loan
One of the most commonly availed types of business loans, a term loan is one where the capital is availed upfront and repaid with interest over a set period of time (term). Typically, they can be broadly categorized into long-term and short-term loans. While short-term loans have a usual tenure of 1 year, long-term loans can go up to 10 years. The loan quantum is usually restricted to 75-85% of the total cost. These loans are best suited for businesses looking for loans to pay for capital expenditures like land and building, construction, infrastructure creation, plant, and machinery needs. The loan amount, length, type of lender, and other factors significantly affect a loan’s eligibility criteria, cost, funding speed, and repayment schedule.
Pros and cons of term loans
- Term loans have a predictable payment schedule
- They have a potential for early repayment
- Term loans, specifically long-term loans, have lower interest rates
- Term loans are usually set in stone, so they tend to be inflexible
- They have strict eligibility requirements, all of which must be met
- Term loans can have a longer approval and disbursement period
2. Working Capital Loan
A working capital loan is the type of business loan that helps a business cover its routine, day-to-day expenses. These expenses can include but aren’t limited to debt payments, buying inventory and raw materials, paying employee wages, managing overhead costs, and paying suppliers.
These loans do not require collateral to be pledged, and the loan amount can go up to INR 30,00,000 depending on the lender and also on the business owner’s eligibility. Several banks and financial institutions today offer working capital loans at varying interest rates. Working capital loans are best suited for businesses with extremes in their sales cycles and would need funds to meet routine needs during the off-season.
Pros and cons of working capital loans
- Working capital loans are typically unsecured loans
- These loans can be spent flexibly (no need to share a business plan)
- Working capital loans have a quick approval and disbursement process
- The repayment tenure for these loans can be shorter
- Default in the repayment can have a huge impact on your credit score
3. Invoice Financing
Invoice financing (invoice factoring/invoice discounting) is the type of business loan where the funds are sanctioned against invoices submitted by the business. The lender can finance up to 80% of the invoice amount. This type of business loan is extremely beneficial for businesses that face challenges due to the gap between raising the invoice and getting the payment. In other words, it is best suited for businesses that are looking to meet their short-term liquidity needs. If the company fails to make payment to the bank/lender, it can use the invoice as collateral.
Pros and cons of invoice financing
- Invoice financing facilitates the liquidation of stuck cash
- It is confidential in nature, i.e., the suppliers wouldn’t know about it
- It doesn’t require pledging of collateral
- Invoice financing offerings are highly subjective. Typically lenders do not offer the scheme against commercial invoices
- Some invoice financing companies charge exorbitant fees
- Invoice financing has a stigma attached to it, often perceived negatively
4. Merchant Cash Advance
In the case of Merchant Cash Advance (MCA), the lender grants the business an advance of capital and purchases a portion of its daily credit and debit card sales. The business can then pay back the advance with a percent of its daily card sales. It is crucial for the business to ensure that there is enough cash flow to manage the payments. The quantum of the loan is quite generous, with the maximum going up to INR 1 Crore, depending on the value of the swipe transactions and monthly card settlement. The tenure for MCA is ideally between 6 to 12 months. If a business cannot avail of any other type of business loan, it can leverage the merchant cash advance.
Pros and cons of merchant cash advance
- Merchant cash advance approval and disbursal process is quick
- The business has to pay only as per the daily sales
- A merchant cash advance allows you to have multiple funding streams
- Cash sales are ignored as the card sales decide the quantum
- A merchant cash advance is one of the most expensive business loans, with annual percentage rates (APRs) as high as 350%
- Lenders, in this case, majorly operate in an unregulated industry
5. Business Overdraft
A business overdraft is a set amount added to a business account by the lender that can be used to help a short-term cash flow issue. When offering this facility, the lender analyses the business cash flow, repayment history, terms of fixed deposits, and more. It is offered primarily to businesses that hold an FD (Fixed Deposit) with the lender. The interest rate is charged only on the utilized amount from the sanctioned limit and on a daily basis. Business overdrafts are particularly helpful for hospitality, retail, and tourism businesses.
Pros and cons of business overdraft
- A business overdraft is instantly available in the business’s account
- Business overdrafts are relatively low cost as the interest is paid only on the extra borrowed amount
- Business overdrafts are completely under the bank’s power
- The funding in business overdrafts is minimal and not ideal for businesses looking for larger funding
6. Equipment Financing
An equipment loan is a type of business loan that helps small businesses get the equipment and machinery they need when they’re short on cash. In most cases, the loan margin is between 10-30%, where the lender loans 70-90% of the capital required. In case of compensation issues, the lender may repossess the machinery and equipment to compensate for the losses. This loan is predominantly availed by construction companies, farming businesses, auto-body shops, shipping companies, and restaurants. Businesses availing of equipment loans also enjoy tax benefits.
Pros and cons of equipment financing
- Businesses completely own the equipment after the loan is repaid. It is then considered an asset
- Equipment financing comes with great tax benefits
- You don’t need to show any collateral to avail of equipment financing
- The equipment depreciates and goes obsolete quickly, which can be a negative
- The loan can be used only to purchase equipment, not for other routine expenses
- The equipment cost is more expensive due to the added interest
7. Loan Against Property (LAP)
As the name suggests, a loan against property or LAP is availed by giving the bank residential, commercial, or vacant land as collateral security. The tenure for repayment in such cases ranges between 3-15 years. Ideally, there are no restrictions against using these funds, and businesses can use this for various purposes, including advertising, business expansion, starting a new business, and more. A loan against property is typically availed when the amount required is over INR 50,00,000. The lender offers up to 70% of the property’s value through the loan. One thing to note is that the loan is granted only if the property is not in the midst of any litigation.
Pros and cons of loans against property
- Businesses can avail large sums as a loan
- Loans against property ensure your finances are not stretched
- The tenure for repayment is long, so the EMI amount can be smaller
- In case of defaults, the bank can sell off your property
- The loan process can take longer due to multiple checks
8. Business Credit Cards
A business credit card is a credit card that is specifically designed for business purposes. The maximum amount available with business credit cards differs with each lender. Businesses can leverage business credit cards to pay for office expenses, computers, business travel, client dinners, and other basic utilities. These cards can be broadly classified into two types: Revolving cards and Charge cards. Revolving cards have a revolving credit limit that decreases and increases as and when you use and repay the credit. On the other hand, a charge card is slightly different in how the amount must be repaid every month.
Pros and cons of business credit cards
- It is easier to get approved for a business credit card than a business loan
- You can build a business credit score, which could help you qualify for loans or other lines of credit
- Interest paid on your card balance may be tax-deductible
- Some business credit cards charge an annual fee and/or foreign transaction fee
- Your credit limit may be less than what you’d qualify to borrow with a loan
- Signing a personal guarantee makes you personally responsible for business credit card debt
9. Letter of Credit
A Letter of Credit is a document issued by a bank that guarantees the buyer’s payment to the sellers. If the buyer cannot make the payment, the bank covers the full or the remaining amount on behalf of the buyer. The bank charges a fee for issuing the same, which also depends on factors such as the risk amount and the type of credit. The typical assets that can be financed through letters of credit include inventory and capital assets.
Pros and cons of letter of credit
- A letter of credit is safer for the seller if the buyer or importer goes bankrupt
- A letter of credit is highly customizable according to the buyer-seller dynamics
- Banks can charge hefty fees to customize the letter of credit
- Letter of credit is highly time-sensitive
Additionally, there are other online lenders who provide business financing, but their interest rates are usually exorbitant. We recommend doing your due diligence before opting for online lenders.
Is There an Alternative to Business Loans?
India has a plethora of options to fund your startup business. At Velocity, we recommend going for revenue-based financing if you want a flexible, highly scalable, 100% digital fundraising process. This founder-friendly approach lets founders raise funds without diluting equity or providing collateral, and the repayments happen as a percentage of monthly revenue. You can learn more about revenue-based financing in our ultimate guide to revenue-based financing.