The basic function of a commercial bank is to make loans and advances out of the money which is received from the public by way of deposits.The loans are particularly granted to businessmen and members of the public against personal security, gold and silver and other movable and immovable assets. Such loans and advances are given to members of the public and to the business community at a higher rate of interest than allowed by banks on various deposit accounts. The rate of interest charged on loans and advances varies depending upon the purpose, period and the mode of repayment. The difference between the rates of interest allowed on deposits and the rate charged on the loans is the main source of a commercial banks income. A loan is granted for a specific time period. Generally, commercial banks grant short-term loans. But term loans, that is, loan for more than a year, may also be granted. The borrower may withdraw the entire amount in lump sum or in installments. However, interest is charged on the full amount of loan. A loan may be repaid either in lump sum or in installments. An advance is a credit facility provided by the bank to its customers. It differs from loan in the sense that loans may be granted for longer period, but advances are normally granted for a short period of time. Further the purpose of granting advances is to meet the day to day requirements of business. The rate of interest charged on advances varies from bank to bank. Interest is charged only on the amount withdrawn and not on the sanctioned amount.
Commercial banks generally lend money in the following form:
- Cash Credit: A cash credit is an arrangement whereby the bank agrees to lend money to the borrower up to a certain limit. The bank puts this amount of money to the credit of the borrower. The borrower draws the money as and when he needs. Interest is charged only on the amount actually drawn and not on the amount placed to the credit of borrower’s account. Cash credit is generally granted on a bond of credit or certain other securities.
- Loans: A specified amount sanctioned by a bank to the customer is called a‘loan’. It is granted for a fixed period, say six months, or a year. The specified amount is put on the credit of the borrower’s account. He can withdraw this amount in lump sum or can draw cheques against this sum for any amount. Interest is charged on the full amount even if the borrower does not utilize it. The rate of interest is lower on loans in comparison to cash credit. A loan is generally granted against the security of property or personal security. The loan may be repaid in lump sum or in installments Every bank has its own procedure of granting loans. Hence a bank is at liberty to grant loan depending on its own resources.The loan can be granted as:
- Demand loans: Demand loan is repayable on demand. In other words it is repayable at short notice. The entire amount of demand loan is disbursed at one time and the borrower has to pay interest on it.The borrower can repay the loan either in lump sum (one time)or as agreed with the bank. Loans are normally granted by the bank against tangible securities.
- Term loans: Medium and long term loans are called ‘Term loans’. Term loans are granted for more than one year and repayment of such loans is spread over a longer period. The repayment is generally made in suitable installments of fixed amount. These loans are repayable over a period of 5 years and maximum up to 15 years. Term loan is required for the purpose of setting up of new business activity, renovation, modernization expansion/extension of existing units, purchase of plant and machinery, vehicles, land for setting up a factory, construction of factory building or purchase of other immovable assets. These loans are generally secured against the mortgage of land, plant and machinery,building and other securities. The normal rate of interest charged for such loans is generally quite high.
- Bank Overdraft: Overdraft facility is more or less similar to cash credit facility. Overdraft facility is the result of an agreement with the bank by which a current account holder is allowed to withdraw a specified amount over and above the credit balance in his/her account. It is a short term facility.This facility is made available to current account holders who operate their account through cheques. The customer is permitted to withdraw the amount as and when he/she needs it and to repay it through deposits in his account as and when it is convenient to him/her. Overdraft facility is generally granted by bank on the basis of a written request by the customer. Some times, banks also insist on either a promissory note from the borrower or personal security to ensure safety of funds. Interest is charged on actual amount withdrawn by the customer. The interest rate on overdraft is higher than that of the rate on loan.
- Discounting of Bills: Apart from granting cash credit, loans and overdraft, banks also grant financial assistance to customers by discounting bills of exchange. Banks purchase the bills at face value minus interest at current rate of interest for the period of the bill. This is known as ‘discounting of bills’. Bills of exchange are negotiable instruments and enable the debtors to discharge their obligations towards their creditors. Such bills of exchange arise out of commercial transactions both in internal trade and external trade. By discounting these bills before they are due for a nominal amount, the banks help the business community. Of course, the banks recover the full amount of these bills from the persons liable to make payment.