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.
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.
Fund-based loans are of different types, each designed to meet specific requirements. Let us discuss the main types.
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.
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.
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 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.
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.
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
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:聽
Fund-based loans directly inject capital into the borrower鈥檚 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.
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.
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.
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.
Fund-based loans are disbursed directly to the borrowers. Some examples include:
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.
Non-fund-based loans help in risk management and trade facilitation. These are the general types:
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 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.
This facility enables businesses to delay payments subject to certain conditions.
Purpose: To ensure liquidity for operations
Example: Importing machinery under a payment schedule.
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.
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鈥檚 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鈥檚 Use | Direct financial liquidity. | Assurances or guarantees. |
| Purpose | Operational or investment purposes. | Risk mitigation or trade facilitation. |
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.
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.
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.
Fund-based loans directly release funds, while non-fund-based loans provide guarantees or assurances without actual upfront funds.
Letters of credit give exporters payment security and assist importers to gain credibility so that trade transactions may be smooth.
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