I hope you have read the previous parts of this series, if not then click here to read.
We were discussing about Long term Debt Asset class under which we had discussed completely about the Securities which further includes Bonds.
Don’t get confused. Let me remind you this hierarchy again.
The parent is Long Term Debt.
The child is Security.
The grandchild is Bond.
In this part, we will discuss about the further categories of Long term debt asset class.
Now, the 2nd child of Long term debt asset class is Other Cash.
This other cash includes Loans. That means the grandchild of Long term debt is Loans.
When we talk about investments or shares or Bonds, then Loans play an equivalent role in that. Don’t only think from the investor’s perspective; do think according to a Managing Director of an investment company or a businessman or a CEO of a listed company.
One must know about each and every aspect of finance sector for emerging as a professional.
According to me, this is the easiest thing which you are going to study because everyone is familiar to this term i.e. Loan. Everyone in his life has definitely experienced about loans. If not, let me remind you, A simple borrowing of money from a friend is also called a loan.
Let us discuss this term with finance perspective:
A loan is the lending of money from one individual, organization or entity to another individual, organization or entity. A loan is a debt provided by an entity (organization or individual) to another entity at an interest rate, and evidenced by a promissory note which specifies, among other things, the principal amount of money borrowed, the interest rate the lender is charging, and date of repayment.
What actually it includes?
It includes the two broad terms, the principle amount and the interest amount.
Principle: This is the amount which is the division of the money borrowed or lent.
For example, if you had borrowed or lent Rs. 12000 to someone for 1 year and agreed for the repayment in 1 year term than the yearly principle amount is Rs. 12000 and the monthly principle amount is Rs. 1000 (12000/12).
Interest: This is the amount which is over and above the principle amount i.e. the charge on loan or in simple terms it is the fees of loan. It is denoted in %age.
For example: You approached one of your friends for loan of Rs. 10000 and he lent you Rs. 10000 at 10% interest rate. Now, this 10% is the interest which has to repaid every month along with the principle amount.
Now, just imagine what is the purpose of Banks or financial institutions?
A layman who approaches the banks for saving of money or fixed deposits is not concerned about the functioning of banks. According to him, bank is a place where he deposits his cash and gets interest amount on that savings in return.
But have you ever tried to think about that from where that bank gives you the interest on your savings?
Let me explain this with the help of an example:
You deposit your money in the bank. After that, your deposited money is used to provide loans to the people on interest means your money reach the another person as a loan and that another person pays interest on that loan amount to bank. Now, that interest amount which the bank has received is used to pay interest on your savings.
I am giving you one small work, just visit the website of any bank and figure out their percentage of interest on money lending i.e. loans and percentage of interest on savings amount. You will see that bank charge higher amount of interest on money lending i.e. loans whereas it pays lower amount on savings money.
You know why?
It’s simple. They do this for generating income.
For example:
There are 3 terms A, B and C.
A is the money borrower
B is the Bank
C is having the savings account in the Bank.
As per the terms and conditions of the bank, they will pay 6% interest on money deposited and charge 10% interest on money lent in terms of loans.
Now, A approached B for loan of Rs. 10,000 and B gave him loan at 10%.
C approached B for depositing Rs. 10,000 in his savings account.
See, what will B do.
B will simply take the money from C and will give it to A. and from here the bank will earn 10% on the same money from A and will pay 6% money on that money to C.
It means bank will overall earn 4% on that Rs. 10,000.
Let’s proceed further.
Types of Loans:
1. Secured
2. Unsecured
3. Fund Based
4. Non Fund Based
5. Term Loans
6. Demand Loans
7. Personal Loans
8. Commercial Loans
9. Working capital finance
10. Project finance
11. Priority sector lending
12. MSME Credit
13. Rural & Agricultural Loans
14. Retail Loans
1. Secured Loans
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as security.
A mortgage loan is a very common type of loan, used by many individuals to purchase things. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security – a lien on the title to the house – until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.
In this category, there is one more concept to understand. Sometimes, a loan is used to purchase a car or other vehicle. In that case, that vehicle itself is used as a security. The duration of these loans are relatively shorter than other types of loans. The duration is not more than the useful life of an asset.
2. Unsecured Loans
In unsecured loans, the borrower’s assets are not pledged as security. Examples of such loans are personal loans, education loans, credit cards etc.
They are given out on the basis of credit worthiness of the borrowers.
3. Fund Based
This is similar to Secured Loan. The Fund based lending is direct form of loans on which actual cash is given to the borrower by the bank. Such loan is backed by primary and / or a collateral security.
4. Non Fund Based
In Non-fund based lending, bank does not make any funds outlay but only gives assurance i.e. bank gives guarantee for the payment on behalf of the person for whom the guarantee has been taken.
The non-funding loan can be converted to a fund-based advance if the client fails to fulfill the term of contract with the counterparty. In banking language, the non-funding advances are called Contingent Liability of the banks.
5. Term Loans
What is a term? It is the time period which relates to some happening of a event.
Similarly, the term loan is the loan given for some specific or fixed duration of time. There are further 3 categories of term loans:
Short Term – less than 1 year
Medium Term – more than 1 year but less than 3 years
Long Term – more than 3 years.
6. Demand Loans
These are the loans which can be recalled by lender anytime on demand. It is a rare form of loan that can be called for complete repayment without any prior warning to the borrower. In other words when the lender demands the money, the borrower must pay it.
7. Personal Loans
The loans which are given to an individual are called personal loans. The credit worthiness (or credit score) of the debtor is major criteria for banks to impart such loan facility.
For example: vehicle loans, education loans etc.
8. Commercial Loans
Whenever any business entity seeks loan for their business, that loan is called Commercial Loan. The credit rating of commercial organizations is one criterion for availing such loans.
9. Working capital finance
A working capital loan is a loan that has the purpose of financing the everyday operations of a company. Working capital loans are not used to buy long-term assets or investments and are instead used to cover accounts payable, wages, etc.
To provide such loans, the lending banks carry out detailed analysis of the borrowers’ working capital requirements and then fix the credit limits. Normally, this loan is a secured loan and the working capital finance is primarily secured by the inventories and receivables of the business.
These loans are taken to fund the operations of the entity which helps in creation of current assets.
10. Project Finance
These loans are granted to finance a specific project of an entity which includes Infrastructural and industrial projects. These loans are long term in nature and generally backed or secured by the future earnings of the entity from that project. Generally, a bank demands project report which includes estimated earnings and ratio analysis on the basis of which the bank decides that whether to grant the loan or not.
11. Priority sector lending
Priority Sector refers to those sectors of the economy which may not get timely and adequate credit in the absence of this special dispensation.
Priority Sector Lending is an important role given by the Reserve Bank of India (RBI) to the banks for providing a specified portion of the bank lending to few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low income groups and weaker sections.. This is essentially meant for an all round development of the economy as opposed to focusing only on the financial sector.
12. MSME Credit
Under this category, loans are granted to Micro, Small and Medium enterprises. These sectors are considered as the priority sector by RBI as these plays an important role in the economic development in the nation.
Capital is supplied through the business finance market in the form of bank loans and overdrafts; leasing and hire-purchase arrangements; equity/corporate bond issues; venture capital or private equity; and asset-based finance such as factoring and invoice discounting.
Meaning of Factoring:
Factoring is a type of finance in which a business would sell its accounts receivable (invoices) to a third party to meet its short-term liquidity needs. Under the transaction between both parties, the factor would pay the amount due on the invoices minus its commission or fees.
Invoice Discounting:
This is similar to Factoring but in this, instead of selling our accounts receivables the entity uses its account receivables as a security for the short term loans.
It is the practice of using a company’s unpaid accounts receivable as collateral for a loan, which is issued by a finance company. This is an extremely short-term form of borrowing, since the finance company can alter the amount of debt outstanding as soon as the amount of accounts receivable collateral changes.
13. Rural & Agricultural Loans
As the name says itself, these are the loans given to farmers for meeting their needs. Rural banks play an important role in these loans. Various times, government subsidized the amount of their loan due to happening of some particular event.
14. Retail Loans
Retail loans is associated with the term Retail banking, also known as consumer banking, is the provision of services by a bank to individual consumers, rather than to companies, corporations or other banks. Services offered include savings and transactional accounts, mortgages, personal loans, debit cards, and credit cards. The term is generally used to distinguish these banking services from investment banking, commercial banking or wholesale banking. It may also be used to refer to a division or department of a bank dealing with retail customers.
So, we have discussed completely about the 2nd category of Long term debt asset class which is Other cash and further includes Loans.
In the next part we will discuss about the 3rd category of Long term debt asset class which is Exchange-traded derivatives which further includes Bond futures, Options on bond futures.
Share this useful info with your friends and stay tuned for more parts.
Kindly Note: The author’s intention is only confined to create awareness about the stock market. Do not take anything as any investment advice as the author do not deals in investment advisory services.
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