Loans vs AdvancesDifferences You Need to Know Between the Two!

There are primarily two sources of funds – there’s equity, and then there’s debt.

Under equity funding, the providers of funds become part-owners of the business.

This is because equity funding is essentially where the fund provider (e.g. investor, shareholder) purchases a stake in the business.

Things are fairly different with debt funding though.

Under debt funding, the fund providers don’t become part-owners of the business.

They simply provide funds… for a fee.

And this fee usually comes in the form of interest.

The usual providers of debt funding are creditors such as banks and other financial institutions.

Debt can come in many forms and among them are loans and advances.

Both of these provide the business with a quick injection of cash.

The business can then use the cash to finance its operations or a planned project.

Loans and advances are a good source of funds if a business needs a little extra cash.

This is especially true if the business is only starting where its source of funding may be limited.

And what’s more, these sources are almost always readily available (provided that the business can ensure that it can repay the debt).

So, since loans and advances practically give the same benefit, they must be the same thing, right?

Well no, not really.

While they do share the trait of being a quick/immediate injection of cash, they do have their differences.

Firstly, the main difference between the two pertains to how a business pays them back.

Loans generally follow a schedule.

For example, a business may have to make monthly principal and interest payments for the repayment of a loan.

On the other hand, an advance doesn’t necessarily follow the same strict schedule.

In this article, we will be discussing more of these differences between loans and advances.

What is a Loan?

A loan generally refers to an amount of cash that one party (the lender) lends to another (the borrower) with the expectation that will be repaid.

Usually, there is a specific purpose as to why a borrower would avail of a loan.

For example, it may be because the borrower is planning to purchase additional equipment or machinery.

It could be that the borrower is planning to construct a new building to increase production capacity.

Or it could simply be that the business needs a quick injection of cash to address immediate payables such as operating expenses.

It is usually the bank and other financial institutions that grant loans.

In addition to the repayment of the principal amount, the borrower also has to pay interest.

One can consider these interest payments as the fee for borrowing money.

The amount of interest will depend on the agreement between the lender and borrower.

Loans are generally represented by a contract.

This contract typically includes the following:

• Name of the lender and the borrower
• Amount of the loan; this represents the amount of cash that the lender will extend to the borrower
• Interest rate; it will also state if the interest rate is fixed or variable
• Term of the loan; this refers to the amount of time before the loan becomes due
• The manner of repayment; will it be a lump sum or will it be in installments?
• If it is installments, the number of payments to be made by the borrower
• Collateral, if there is any; collateral refers to an asset that the borrower owns that the lender may require to secure the loan; it is usually of the same or higher value than the amount of the loan
• It may also include an annex that shows the schedule of payments

Specifics of a Loan

Now while I did say that loans are a great source of funds because of how almost always readily available they are, it not like lenders will extend loans to just anyone.

I mean, you wouldn’t lend money to someone if you’re not sure that you’ll get repaid, right?

Usually, before lending out any money, the lender will perform certain procedures to assess the borrower’s credibility.

First and foremost, the lender would want to know if the borrower has the capacity to repay the loan.

If the borrower fails this check, the lender may immediately refuse to extend a loan.

Or it might still approve the loan if the borrower can provide appropriate collateral.

Aside from assessing the borrower’s capacity and ability to provide collateral, the lender may also consider the borrower’s character.

If the borrower is a repeat borrower and has demonstrated that s/he can repay his loans on time, then that is great character.

The lender may then grant the loan even if the borrower’s current capacity is lacking just because of his/her character.

Now while there are loans that have a term of one year or less, loans usually carry with them terms of more than a year.

Meaning that the repayment period is usually not immediately within the year when the loan is granted.

We can classify loans based on the following parameters:

Based on Security

• Secured Loan – when a loan is secured by collateral, it is considered a secured loan. In the event that the borrower is unable to repay the loan, the lender may acquire the collateral as payment instead.
• Unsecured Loan – if a loan has no attached collateral, then it is an unsecured loan. Unsecured loans usually come with higher interest rates than secured loans due to their unsecured nature.

Based on Repayment

• Time Loan or Lump Sum Loan – this refers to a loan where the entire amount of the loan (plus any interest) is to be paid at a certain future date. The payment is a one-time payment.
• Installment Loan – this refers to a loan where payments are made in installments. It could be equal payments, or variable payments depending on what’s stated on the contract. Every payment has a principal and interest component. Meaning that a portion of the payment goes to the repayment of the principal amount, while the other portion is to pay for interest.
• Demand Loan – this refers to a special type of loan where payments are to be paid upon the request or demand of the lender. This is unlike the previous two loan classifications where payments follow a schedule.  

What is an Advance?

An advance refers to a certain amount of money or credit that a bank or any other financial institution provides to a business establishment or individual to answer short-term financial requirements.

We can also define it as a credit facility that a bank or financial institution provides to a business to cover daily fund requirements (i.e. working capital).

It is essentially a source of funds that the business can rely on if it doesn’t have the immediate cash to pay for daily expenses such as salary, wages, rent, etc.  

An advance usually has a short-term. In fact, another name for an advance is a short-term loan.

The main draws of advances are their fast approval and quick funding. It is like another wallet that the business can reliably draw cash from.

An example of an advance is a credit card.

A credit card allows a business or individual to pay for expenses without having to fork out any cash on the go.

Instead, the business can use the credit card up to its credit limit.

Then the business pays for any accumulated credit when they become due.

Usually, it’s a month after the next credit card statement date.

Depending on the type of advance, it may carry steep interest rates and fees (especially credit cards).

But the fact remains that advances provide a business with a quick and reliable source of funds should it need the extra cash.

Loans vs Advances

While both loans and advances provide a business with an immediate injection of cash, they have their differences.

Let’s list down these differences:

Purpose

A business is more likely to avail of loans if it wants to gather funds to finance the acquisition of a capital asset.

This could be a purchase of additional equipment and machinery. Or it could be the construction of a new production plant.

On the other hand, a business is more likely to avail of advances if it needs extra cash to pay for operating expenses.

Advances are ideal for addressing short-term financial needs.

Amount

Loans usually have higher limits than advances when it comes to amount.

This is why loans are more conducive to financing huge purchases or expenditures than advances.

When a business is looking to finance a huge expenditure such as the expansion or construction of a building, purchase of high-value assets, etc., the better choice is to go for loans due to the higher limit.

Since an advance is a credit facility by nature, it naturally will have a lower amount limit than that of a loan.

An advance isn’t meant to cover huge finances though.

It is there to address short-term financial needs, which are comparatively smaller than the amount that a loan can cover.

Payment Duration (and Interest)

Loans are usually long-term debts.

Meaning that their repayment period will typically stretch for more than a year.

For example, a typical home loan can have a repayment period of 5 years and can go up to 30 years.

Due to the long repayment period, loans require the payment of interest on top of the principal payments.

On the other hand, advances are always paid within one year or less.

This means that advances are always short-term debts.

Some types of advances even require payments within one or two months from when they are availed of.

 Due to the shorter term, they usually carry lower interest costs.

Some advances may also not carry interest costs, but rather steep penalty fees when payment is late.

This encourages timely payments. It also supports the short-term nature of advances.

Security

When the amount of a loan is very high, the lender may require collateral from the borrower.

The collateral then acts as a form of security for the lender.

Should the borrower be unable to pay for the loan, the lender can seize the collateral, though there is usually a grace period before the lender seizes the collateral.

Collaterals are often high-value assets such as a building, gold, land, etc.

On the other hand, due to the relatively lower amount that an advance covers, it typically does not need collateral.

Though it will still depend on the lender. Some may require the borrower to submit a fixed deposit to secure the advance.

Formality

The process of getting a loan is more formal than that of an advance.

Before extending a loan, the lender will perform several procedures to assess the borrower’s credibility.

There are also administrative procedures that the borrower has to go through.

The lender may also require certain documents from the borrower.

Overall, the process of getting a loan is more formal and strict.

On the other hand, the process of getting an advance is looser by comparison.

The borrower only needs to meet the predefined requirements set by the lender.

The screening process is also less stringent compared to that of getting a loan.