Bank Loan: Characteristics, Functions, Importance, Types
What is Bank Loan?
Bank takes surplus funds from its customers in its custody and temporarily provides or transfers them for a specific duration in exchange for some interest or profit as a loan.
A loan is a formal agreement between a bank and a borrower to provide a fixed amount of credit for a specified period.
As a profit-oriented business organization, we can easily say that if a bank gives its resources temporarily under certain conditions, it will be called a loan. Bank gives loans for profit-earning purposes.
Table of Contents
Characteristics of Bank Loan
To fulfill this purpose, bank loans must have some important characteristics.
10 Characteristics of a bank loan that makes it different from other types of loans are;
- Amount of loan.
- Ultimate decision.
- Mode of the loan.
- Nature of distribution.
- The process of disbursement.
- Loan price.
- Periodicity’ of bank loans.
- Repayment of loan.
There are two parties involved in the loan transactions. One is the bank, and the other is the loan applicant. The applicant will apply for loans from the bank, and the bank will accept the application. Bank can reject the application if found financially not viable.
Amount of Loan
The loan amount may be tiny, medium, or large. There might be a difference between the applied amount and the sanctioned amount based on the quality and capacity of the borrower and the purpose for which it is applied.
Bank’s decision is final in the case of the loan application. That is, the bank can fully sanction, partially sanction, or may totally reject the loan application after considering the goodwill of the clients, its own fund, and other issues related to creditworthiness.
Mode of Loan
Generally, loans are given in cash. But in exceptional cases, the same may be provided in kind, such as raw materials, machinery, other inputs, etc.
Nature of Distribution
Generally, banks disburse loans on an installment basis. But when the bank is convinced, it may disburse the whole amount of sanctioned amount at a time.
Process of Disbursement
Banks often disburse their loan against the existing current account of the client. If the client is new, the bank asks the person to open a current account. The bank provides the sanctioned loan through that account.
Generally, loans are provided against collateral. But sometimes, a small number of loans can be sanctioned based on a personal guarantee.
Banks never sanction loans without interest. But interest rates can vary based on the types of loans or track records of the clients.
Periodicity’ of Bank Loan
Depending on the type of loan, the goodwill of the clients, and the purpose, the periodicity of the loans can vary. The loan may be sanctioned for immediate use on a short-term, mid-term, or long-term basis.
Repayment of Loan
Loans are repaid on an installment basis or maybe a one-shot arrangement. In preparing the loan repayment schedule, banks generally focus on the possible cash flow stream of the clients’ projects. At a glance, these are the characteristics of bank loans generally that are seen in the case of every’ commercial bank.
Functions of Bank Loans
Loans cannot be collected without price. Nobody can afford to keep something idle and unproductive purchased at a competitive price. Individuals or corporate houses usually take loans. Functions of such bank loans include, among others, the following:
These points are described below;
Functions provided to individuals by Bank Loans
Banks give loans to individuals to purchase necessities that they cannot buy with limited financial means. The loans, which fall under this category, can be of the following types:
Consumption demand for durable goods often individuals can not afford from regular personal inflows. Banks nowadays give loans for these purposes according to the customers’ needs.
The loans may be granted to buy costly furniture, freeze, tv, computer, laptop., etc. While extending such loans, banks want to be sure that the potential borrowers have regular sources of adequate income.
People of limited income face problems in building their own houses. Banks provide house loans payable to people at the end of a specific term in exchange for some interest. Thus banks succeed to a great extent in solving the housing problem of the urban people.
Banks give loans to customers to buy automobiles for commercial use or personal use for comfort. Loans for private cars, office cars, trucks, buses, etc., are included.
Registering the gifted/willed assets at the time of handover is necessary. Registering such assets may be very costly for the person who receives the assets. In this case, banks, on assurance of the mortgage of the gifted property, give loans to meet the registration expenses and thus help the client acquire the asset.
Education and medical loan
Education and medication are the two basic needs of humans. Commercial banks sometimes provide loans to pursue studies or defray medicare expenses when they become sure about the repayment from such clients.
Holiday tour loan
To increase the pleasure from traveling & tours, banks provide holiday loans to those with a definite source of adequate regular income.
Wedding and social ceremony Loan
Man is a social being. Different rituals and social ceremonies are required to be observed in society. Sometimes, it is difficult for fixed-income persons to bear the expenses of a wedding or any other ceremony. Banks help clients bear the expenses required for performing such ceremonies by providing loans.
Functions Provided to Business Organizations by Bank Loans
Businesspersons and business institutions ignite the economic progress of a country. Banks participate in this process by providing loans to business houses/ organizations. Let’s discuss the purposes for which business organizations take such loans:
Working Capital Loan
Suppose business organizations face problems in production due to a lack of working capital, mostly to procure raw materials, fuels, accessories, etc. In that case, banks help them by lending them money to arrange those and thus assist the business organizations.
Seasonal Deficit Loan
Some business organizations need more capital in some seasons because of the great seasonal demand. Commercial banks provide loans for the deficit capital to buy raw materials and other related inputs.
Economic cycle Requirement Loan
In a recession, banks may need loans to recover from the bad times. With this type of loan, production is Employment, and national income may also be increased. And at last, the economic condition of the country will be improved.
Asset replacement loan
Business institutions need loans for the replacement of fixed assets. This type of loan helps business organizations to repair and reestablish the tom out and old assets and
Asset Acquisition Loan
In light of competitors’ demonstrations, a business organization may plan to acquire newly developed machines or other assets for which the bank may extend loans.
Public limited companies must fulfill some formalities to be listed on the stock exchanges. When short of funds, they may require additional financing for the purpose.
Banks, when finding reasonable, extend loans to such companies that, from raising money through new issues, arrange to repay the loans. The purpose of this loan is to make the business organization capable of issuing shares.
The export-import business helps the economy to grow fast. The exporters and importers are helped to augment the volume of their businesses with additional loans from the banks. Banks also help these business houses by issuing L/C and even standing by L/C for a particular period of time.
Importance of Bank Loan
A bank is an important tool of economic development for any country. Bank loans are required to use improved technology to increase the volume of production in the agriculture sector and facilitate business activities.
Researches support the fact that economic and financial development is highly correlated to banking and financial system development.
The more developed and efficient the tire banking sector of a country is, the more developed the business industry sectors will be.
Like agriculture and farming, the primary sector is also significantly dependent on the banking system; the supplied credit largely determines quality inputs to be adequately arranged on time on easy terms & conditions.
Areas of the importance of Joan are given below:
- Importance of bank loans in trade and commerce
- Creation of credit deposits
- Increased formation of capital
- Increased volume of investment of capital & working capital
- Raise the proportion of the sectoral GDP to the total GDP.
- Importance of Ioan in international business
- Financing Export Import
- Discounting bill of Exchange, bank draft, etc.
- Regional development
- Importance of loans in agriculture –
- Crop credit
- Cash crop credit
- Horticulture credit
- Warehouse credit
- Rural housing credit
- Poultry and fisheries
- Small and cottage Industries credit
- Improved technology credit
- Improved seed credit
- Chemical fertilizer credit
- Other tools & machines credit
- Importance of providing Consumption
- Housing loan
- Education loan
- Car loan
- Marriage loan
- Self Employment loan: This type of loan aims to help unemployed but industrious young persons be engaged in income-generating activities. The types are:
- Women’s self-employment loan.
- Technician self-employment loan.
- Shopkeeper self-employment loan.
- Small Business self-employment loan.
If we observe the above-mentioned activities, we can say that bank loan is essential for the country’s economy. Generally, these activities are operated to achieve two main objectives:
- Profit-directed loan activities
- National priority-directed loan activities
Though the second types of activity are not sufficient for the banks to earn an instantly higher rate of profit but such types of loan activities improve the life standard and employment opportunity of the disadvantaged segment of the population.
This will eventually increase the opportunity to collect more deposits shortly and will certainly raise die demand for loans in a larger number of bankable projects.
Classification of Bank Loans
A bank is an institution that is engaged in the business of money and loan. The more loans a bank provides, the better and more beneficial the bank will be. The loan should be provided to the appropriate users, and they must be monitored to ensure the repayment of principal and interest as and when it becomes due. Loans can be of different types according to the terms, users, and security.
In the following chart, the classifications of loans are depicted:
Types of loans are discussed below
Types of Loans Based on Users
- Consumer Loan: Banks provide loans for durable goods/ appliances and commodities like – loans for Freeze, TVs, computers, cars, Furniture, etc.
- Housing Loan: This includes loans given to fixed or low-income people for housing. This loan is usually intermediate and or long-term.
- Education/Medical and Other Loans: Some of the banks also provide loans to the people of the society to meet their educational or medical needs after being sure about the repayment
Industry loans can be of two types.
- Working capital loan: This type of loan is given to the business/ industry to provide the capital required for purchasing raw materials, paying wages and fuel expenses, etc.
- Fixed capital loan: A huge amount of capital is required for procuring and replacing machinery/equipment for industrial organizations.
Loans for business persons
- Working capital loan: Business persons need a great _ deal of working capital to maintain day-to-day transactions. By providing working capital loans, banks help solve the business persons’ working capital necessity.
- Export-Import Loan: Banks also help export-import firms/companies by issuing L/C, bills of exchange, discounting, and direct loans.
Loans for Farmers
- Crop Loan: For buying seeds, cows, and fertilizers, farmers need money. They borrow money from the bank to meet their expenses.
- Non-crop loan: Farmers also need money for poultry, fisheries, agro-business, agro-processing, and other purposes. In this case, socialized/commercial banks provide small/ medium loans to farmers.
- Farming equipment loan: Banks also provide loans to fanners to purchase farming equipment. Fanning equipment may include – power tillers, tractors, machinery for irrigation,
Loans for landless people
For the people that own no land, the different types of loans that are usually provided to landless people are given below:
- Small business loans: Banks may provide loans to landless people to establish income-generating micro-enterprises, small businesses, poultry farms, or fisheries. The purpose of banks is to help landless people overcome financial distress and build up some capital for future investment.
- Housing loan: Bank may provide housing loans to those with a small piece of land but don’t have any resources to erect a house to protect them from rains and the sun shines besides earning social status and protection from thieves.
- Medical Ioan: Loans may also be given to landless people for medical purposes.
Types of Loans Based on Term/Periodicity
Types of Loans Based on term/periodicity, loans can be of three types:
This loan is sanctioned for less than one year. These can be of two types;
Loans provided for immediate use & payable on demand
Loans payable on short notice
Usually, loans with a maturity of I to 5 years are called mid-term loans. However, commercial banks give midterm loans of maturity of 1-3 years.
Loans with more than five years of maturity are called long-term loans.
Types of Loans Based on Security
Types of Loans Based on Security:
Banks often provide loan without any collateral to reliable persons or institutions as clients having profound goodwill and excellent track record or sometimes to indigent clients.
Fully secured loans
If the loan is given by taking the security/collateral of the amount exceeding the loan amount or just equal to the loan amount, it is called a “fully secured loan.”
Partly secured loans
If an Ioan is not fully secured, a partial amount of collateral is provided to cover the sanctioned loan; it is called a “Partly secured loan.”
Loan Grading or Classifications Based on Recoverability
Here, by loan grading or classification, we mean the types of loans based on the probability of collecting the full loan amount. The customer who repays their loan according to the initial agreement is recognized as the Prime Customer.
Based on the probability of recovery, loans can be classified into six groups. Such as:
- Prime loans.
- Satisfactory loans.
- Good loans.
- Substandard/Marginal loan.
- Doubtful loan.
- Bad loan/Loan loss.
The abridged classification can be shown as:
- Good loan – The recovery of a loan is unquestionable
- Doubtful loan – may be realized or not, if realized may not be to the fullest extent.
- Bad Loan/Loan Loss means the irrecoverability of such a loan is almost sure and cent percent.
Now, let’s observe the schedule of problem loans:
From the above schedule, we can conclude that risks of loan collection and loan review are interrelated. A loan review is not required if the possibility of the collection is unquestionable.
On the other hand, the lower will be the collection possibility, the higher will be the problem loans. In this case, to keep the problem loans within a lower limit, extensive loan review is required.
Types of Loans Based on Maturity
According to maturity, loans can further be divided into short-term and long-term. Though, a mid-term loan is also provided. There is no hard and fast strict rule to determine short-term or long-term loans.
A bank can categorize the same loan as short-term, and another bank can consider the same as long-term or mid-term.
Types of Loans Based on Maturity are explained below;
- Short term loan
- Fixed loan
- Revolving credit
- Stand by the credit line.
- Term loan
- Serial credit
- Revolving credit line
- Non-revolving credit line
Let’s see the maturity classification of loans differs from the following table:
|Nature of maturity||Characteristics|
|Short term loan||Maturity may vary but usually up to one year.|
|Fixed loan||Loan for a set/fixed period usually predetermined 3 months to any period.|
|Revolving credit||Can borrow & re-borrow the same amount on the repayment.|
|Stand by the credit line.||Firm assurance of credit arrangement based on commercial paper. L/C etc., Bank guarantees that it will make funds available to the issuing firms at the time of their need by redeeming the commercial paper.|
|Term loan||The maturity extends beyond one year.|
|Serial credit||It is the credit facility for a specific amount and specific terms (more than 1 year), which can be renewed at the maturity’s end after paying the previous loan amount.|
|Revolving credit line||It is the credit facility for a specific amount and specific terms (more than one year), which can be renewed at the maturity’s end after paying the previous loan amount.|
|Non-revolving credit line||A designated amount beyond one year but does not have the automatic facility to borrow again- needs to be processed for new loan cases.|
Documentation of Loans
Credit activity is a risky function for a bank. For successful credit activity, a bank should collect the necessary documents from the borrowers. With these documents, a bank can take legal action against the borrower in case of default.
Both borrower and lender must sign every document. Thus the proper documentation gives the bank a right to save its interest.
The following documents are commonly used for approving a loan or other types of businesses.
- Original loan agreement.
- Filling up the loan application form.
- Financial statements of the borrower.
- Credit analysis report.
- Proofs of certificates and documents of the collateral.
- The name and signature of the authorized person/attorney of the borrower.
- A copy of the resolution of the board of directors of the borrowing company.
- A copy of the partnership deed and the statement of the assets in case of the partnership business.
- The surety from the authorized person of the company.
- Financial statements of the person or the company providing surety in favor of the potential borrower.
- The copies of the written communication and other information exchanges between the bank and the borrower.
- Mortgage and trust agreement.
- Certificates of earnest money are given on assets.
All the above documents are needed to be preserved in the loan file of the borrowers. However, required documents vary with the type of loans and loan-taking persons/organizations.
Some of these documents are usually used for different types of loans.
- Fixed Deposit Receipt (FDR).
- Letter of Attorney.
- Demand Promissory Note.
- Letter of Continuity.
- Deed of Hypothecation.
- Letter of Guarantee.
- Mortgage of Property.
- Latest Stock Statement.
- Letter of Undertaking.
- Policy in original duly assigned in favor of the bank.
- Notice of Assignment.
- Stamped Letter on Lien.
- Standing instruction to the bank for payment of promises to the debit of borrower account.
- An undated letter signed by the policyholder giving consent to surrendering the policy
- Notes or Bonds duly endorsed in favor of the bank.
- Memorandum of Deposits.
- A declaration from the party that the securities are the borrower’s property and free from all encumbrances.
- Letter of credit from the third party.
- Delivery Note of Securities.
- Certificate of the approved gold tester.
- Declaration of ownership by the borrower.
- Legal Assignment of Debt.
- Power of Attorney executed by the borrower in favor of the bank.
- Agreement for pledge or agreement for each credit.
- Letter of lien (containing set off clause).
- Insurance policy covering goods against all risks.
- Invoice of goods pledged.
- Delivery of possession of going down.
- Certificate for registration of charge (in case of companies).
- Mortgage of property, if any, as collateral security.
- Letter of instructions for collecting bills/checks from places where the bank has no branches or agencies.