Methods of Advancing Loans by Banks

There are four reliable methods of advancing loan by banks. As we know that “banks borrow to lend”. After keeping a portion of the total deposits, as cash reserve, the balance amount is either invested or advanced to needy persons and businessmen to earn profit. Hence for this purpose, bank advances his balance cash by using different methods. These methods are known methods of advancing loans from bank.

Methods of Advancing Loans

The commercial bank uses the following methods of advancing loans to his customers;

• Over draft
• Cash credit
• Fixed loans
• Discounting bills of exchange

1. Over Draft

By this method of advancing loans, banker allows his reliable customers to draw over and above the money actually deposited by them in their accounts. This facility is allowed through cheque only to the current account holders, but only to those, who have good financial and credit standing. These advances are given on the basis of personal securities. The civil officer and other salaried persons are also allowed overdraft equal to their six months’ salary with the condition to deposit their salary bill with the bank till the recovery of the overdraft. Interest on overdraft is charged on the basis of daily debit balance on actual amount drawn from the date. It is the easiest way of advancing loans from bank, bank earns profit and on the other side, the borrowers is temporary accommodated and can be able to meet with the short term requirements for money with the facility of overdraft.

2. Cash Credit

Another method of advancing loan is cash credit method. By cash credit arrangements, a customer is granted an advance up to a certain limit, which he can draw from time to time required by him. In this method of advancing loans, bank pens a loan account in the name of the borrower and honors the cheques drawn by him. On this type of loan, the interest is charged on the amount actually utilized. If funds remain idle, bank looses interest and some bankers make it essential to charge interest on some part of cash credit form the customer, whether the customer utilize it or not. Cash credit is a short term commercial loan, which is advanced to businessmen and industrialists against tangible securities. This is the most popular way of borrowing by large commercial and industrial firms due to facility of drawing the amounts as and when desired. However, in this method of advancing loans, banker should observe some precautions while advancing loans. Banker must be satisfied with the honesty and credit standing of customers. As John Pager said “Provided the banker is dealing with honest and responsible person documents of title to goods are convenient securities for advances. Moreover, the banker should be familiar with the different market, and should advance against saleable commodities puts as the security for the loan granted.

3. Fixed Loans

Under this method of advancing loan, the bank advances in fixed amount repayable either in fixed monthly or yearly installments or in lump sum. It is usually borrowed to meet with the long term requirements for capital. Interest is charged on the full amount of the loan sanctioned for whole of the period, whether utilized or not by the borrower. These types of loans are granted against security like gold ornaments, real state, machinery, stock and bonds. These securities are put to cover the risk for the return of the loan. However, some un-secured loans are also provided to the customers having good credit ranking. Different loans are advance for different purpose and periods, it includes consumer loans, industrial and commercial loans and agricultural loan for a short, medium and long term periods.

4. Discounting Bills of Exchange

It is another way of advancing loan to the customers. Bank discount the bill of exchange held by the businessmen, which are payable after a certain period of time. Banks pay the holder of the bill and amount equal to their face value after deduction of interest at the current market rate for the period the bill has to mature. By discounting bill of exchange, a bank accommodates his customer for short term requirements for cash. The bills of exchange are very liquid asset to hold, because on their maturity, they can easily be turned into cash.

Principles of Advancing Loans

We also know that bank deals with other people’s money, so any banker before making any advance, will have to consider many factors for the proper investment and safe return of the principle amount along with the profit expected. These principles are as under;

1. Principle of safety

It is the basic principle of the use of the bank’s fund. There should be full security and safety of the return of the money advanced. For this purpose, bank asks for different kinds of guarantees and securities to cover the risk of advances. In case of loss, the amount advanced is covered by selling the securities offered for loans.

2. Principle of liquidity

It is in the interest of the bank to keep his money in a liquid form, convertible easily into cash, as and when desired by the bank. So bank invest his money in the short term advances and avoids in any long term financing like land, buildings and purchase of machinery.

3. Diversification in loans

At the time of advancing loans, bank should satisfy himself about the purpose and use for which loan is advanced. For non-productive or illegal business no advance should be granted.

4. Financial position

Banker before advancing any loan should satisfy himself about the character, financial position and mode of repayment of the loan. Loan should be granted in accordance with the financial position of the firm or industry. Beyond the capacity, no loan should be granted, because there will be a great risk in the repayment of the loan.