A fund-based loan is an advance provided by the bank or any financial institution to the borrower from its funds for business or personal purposes. Fund-based loans enable companies or individuals to raise capital for working capital, expansion, or asset purchases. Unlike a non-fund-based loan, which is a guarantee or assurance without the immediate release of funds, a fund-based loan injects liquidity directly into the account of the borrower.
This article provides insight into the meaning, types, and characteristics of fund-based loans and compares these with non-fund-based loans, focusing on the importance of modern finance.
Meaning of Fund Based Loan
Fund based loan is a financial instrument wherein the actual fund is released to the borrower. These loans play a crucial role in the ecosystem of finance; they are of prime importance, as they generate much-needed liquidity for businesses as well as people. Borrowers use such funds for operations, investments, or personal expenditures.
The most prominent feature of fund-based loans is that the lender agrees to transfer funds to the account of the borrower immediately after approval. Unlike non-fund-based loans, which are based on assurances, fund-based loans involve actual monetary transactions.
Types of Fund-Based Loan
Fund-based loans are of different types, each designed to meet specific requirements. Let us discuss the main types.
Term Loans
Term loans are issued for purchasing fixed assets, such as machinery, buildings, or vehicles. The borrower pays the loan in equal installments over a specified period.
- Purpose: Long-term capital investment.
- Example: A company buying machinery for manufacturing.
Working Capital Loans
These loans meet the short-term operational needs of a business, such as inventory purchases or day-to-day expenses.
Purpose: To ensure smooth operations.
Example: A retailer raising funds to stock inventory during a festive season.
Overdraft Facility
An overdraft enables borrowers to withdraw sums exceeding their account balance within an agreed limit. This facility ensures that companies or individuals operate within a well-managed cash flow.
Use: To service unexpected or pressing financial requirements.
Illustration: A company with a need to raise funds to fulfill an unscheduled bulk order.
Trade Finance
Trade finance loans are given to facilitate either domestic or foreign trade transactions. These may range from financing purchases of raw materials to ready products.
Use: For the facilitation of trade activities.
Example: Importers accessing funds to clear customs.
Letter of Credit Loans
Letters of credit are also a form of hybrid as they ensure liquidity for importers/exporters under agreed terms, which is part of trade finance.
Features of Fund-Based Loans
Fund-based loans are essential financial tools that provide immediate liquidity to businesses and individuals. Understanding their features can help borrowers leverage these loans effectively for their financial goals
- Direct Fund Disbursement: The lender provides actual funds to the borrower, ensuring immediate liquidity for personal or business needs.
- Interest-Based Repayment: Borrowers pay interest on the disbursed amount, which can vary depending on the loan type and tenure.
- Secured or Unsecured Options: Loans may require collateral (secured) or can be availed without any security (unsecured), based on creditworthiness.
- Purpose-Specific Loans: Fund-based loans cater to various needs like working capital, asset purchase, or operational expenses.Immediate liquidity upon approval.
Importance of Fund-Based Loans
Fund-based loans are an important kind of financial tool through which direct liquidity support to both the individual and the business people in the economy. The reasons for their significance are as follows:
Direct Liquidity Support
Fund-based loans directly inject capital into the borrower’s account, ensuring immediate financial support. This makes them an essential tool for meeting short-term operational needs or long-term investments. Businesses rely on these loans for maintaining cash flow, purchasing inventory, or funding growth projects.
Example: A small business may use a working capital loan to manage seasonal fluctuations in demand.
Business Expansion
These loans allow companies to invest in expansion opportunities. Whether acquiring new assets, upgrading infrastructure, or entering new markets, fund-based loans provide the necessary financial backing for growth.
Example: A manufacturing firm taking a term loan to purchase advanced machinery to increase production capacity.
Flexibility in Usage
Fund-based loans give the borrower the flexibility to use the funds as per his requirements. From operational expenses to capital investments, borrowers can allocate the resources based on their immediate and future priorities.
Economic Activity Boost
Fund-based loans ensure that the funds are readily available to the businesses. This stimulates economic activity because it enables enterprises to sustain operations, pay wages, procure raw materials, and produce goods. This contributes to economic growth and job creation.
Examples of Fund-Based Loans
Fund-based loans are disbursed directly to the borrowers. Some examples include:
- Term Loans: A manufacturer securing a loan to buy production equipment.
- Working Capital Loans:Â A retailer borrowing funds to buy seasonal inventory.
- Overdraft Facility: A business using an overdraft facility to bridge short-term cash flow gaps.
Meaning of Non-Fund-Based Loan
Non-fund-based loans do not involve the immediate disbursement of money. Instead, they comprise commitments or guarantees offered by banks to third parties on behalf of the borrower. In such arrangements, the lender does not transfer funds unless a contingency arises.
Types Non-Fund-Based Loan
Non-fund-based loans help in risk management and trade facilitation. These are the general types:
Bank Guarantees
Banks undertake to make payments to a third party when the borrower is unable to do so.
Purpose: To reduce business risks.
Example: A contractor offering a performance guarantee to the client.
Letters of Credit
Letters of credit are guarantees made to pay the sellers on behalf of the buyers, usually utilized in international trade.
Purpose: To facilitate international transactions.
Example: An exporter getting payment assurance from the bank of the buyer.
Deferred Payment Guarantees
This facility enables businesses to delay payments subject to certain conditions.
Purpose: To ensure liquidity for operations
Example: Importing machinery under a payment schedule.
Characteristics of Non-Fund-Based Loans
Non-fund-based loans are instruments where banks or financial institutions give guarantees or commitments rather than disbursing actual funds. These loans play a vital role in trade, projects, and risk management. Their structure is unique and, therefore, cost-effective and appropriate for businesses requiring security assurances without immediate liquidity.
- No Cash Outflow: There is no immediate cash outflow in such loans, as it does not require the upfront transfer of funds but gives financial assurance to third parties.
- Enhanced Credibility: They strengthen the borrower’s reputation by ensuring compliance with financial or performance obligations.
- Cost Efficiency: Borrowers incur lower costs, paying guarantee fees rather than interest on disbursed amounts.
- Risk Management: They protect third parties against default risks, thus facilitating smoother business operations.
Difference Between Fund Based loan and Non Fund Based Loan
Fund-based loans and non-fund-based loans serve distinct purposes in financial management. While fund-based loans involve the direct disbursement of funds to meet operational or investment needs, non-fund-based loans revolve around guarantees or commitments without any upfront cash flow. Understanding these differences is essential for businesses and individuals to choose the right financial solution based on their specific requirements, whether it’s for liquidity or risk mitigation
| Aspect | Fund-Based Loan | Non-Fund-Based Loan |
| Nature | Immediate disbursement of funds. | No immediate fund disbursement. |
| Examples | Term loans, working capital loans. | Bank guarantees, letters of credit. |
| Risk for Bank | Higher as funds are released directly. | Relatively lower as funds are conditional. |
| Borrower’s Use | Direct financial liquidity. | Assurances or guarantees. |
| Purpose | Operational or investment purposes. | Risk mitigation or trade facilitation. |
Fund Based Loan FAQs
What is a fund-based loan?
A fund-based loan directly involves disbursing funds directly to the borrowers for conducting their business operations and investments or personal use. Examples include term loans, overdrafts, and working capital loans.
Can a borrower apply for both fund-based and non-fund-based loans?
Both types are applied by borrowers, but they make different uses of the two. Fund-based loans handle liquidity issues, while non-fund-based loans create security in trade or contracts.
What is the difference between a term loan and a working capital loan?
A term loan applies to long-term investment, such as the buying of equipment, which will eventually be paid back. The working capital loan covers daily operations and short-term needs.
How do fund-based loans differ from non-fund-based loans?
Fund-based loans directly release funds, while non-fund-based loans provide guarantees or assurances without actual upfront funds.
Why are letters of credit so important in international trade?
Letters of credit give exporters payment security and assist importers to gain credibility so that trade transactions may be smooth.
