What is a Demand Loan?

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Typically, lenders grant demand loans to the borrowers against collateral at a floating interest rate. Borrowers can use land, buildings, vehicles, or fixed deposits as collateral to secure these loans. They can be closed at the discretion of the lender or the borrower or as per the terms of their agreement. Call loanCall LoanA call loan (CL) is a type of short-term loan that the borrower must repay immediately at the lender’s request.read more is the most common form of demand loan. Furthermore, this loan is also called a working capital demand loan as it is taken to finance the short-term capital needs of businesses like payroll, rent, purchases, etc.

Key Takeaways

  • A demand loan is a loan that has to be repaid by the borrower on the lender’s demand.Every DL is issued for a short duration ranging from seven days to a few months against collateral security.DLs are mostly availed for meeting short-term financial or capital requirements.Unlike DL, term loans are fixed long-term loans with a set repayment schedule. Lenders cannot recover them on-demand.A call loan offered by banks to brokerage houses is an example of DL, whereas a housing loan is a typical example of a term loan.

Demand Loan Explained

The demand loan is a loan agreement between the lender and the borrower, which enables the lender to demand the loan repayment at any time. For DL, collateral is a must. The lender and borrower enter into an agreement specifying the amount and tenure of the debt, interest payableInterest PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company’s balance sheet.read more, and call back option available to the lender.

Under this arrangement, the borrower can also settle the loan anytime. Unlike usual loans, there is no fixed maturity date or repayment schedule. The lenders charge a floating interest rate on loans as per the demand loan agreement. The interest rate is higher than the prime lending rates of the bank and is payable according to the terms specified in the contract.

The loans are of shorter duration, starting from seven days to as much time agreed upon by both parties. It involves the least documentation and takes lesser sanction time. The terms of the loan depend on the credit rating or history of the borrower. Businesses or individuals with a weaker credit score or a shoddy credit history can also utilize such loans. Thus, banks must practice due diligenceDue DiligenceDue diligence is a thorough examination of information and strict adherence to the applicable rules and regulations. It ensures asset protection as well as the avoidance of malpractices and conflicts.read more before sanctioning them.

Usually, banks find it safer to disburse this type of loan since it has collateral security. In case of default, they can recover their loan by encashing the value of the collateral. Moreover, they also benefit from a steady flow of interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more from them. Therefore, DL is an attractive source of income and an important means to improve their asset quality.

Furthermore, it is the most convenient form of loan for businesses as the loan does not have any prepayment penalty.Prepayment Penalty.The prepayment clause states that if payment is made in advance before the due date, then terms and conditions of the mortgage are not adhered to by the borrower and would be liable to pay the penalty known as the prepayment penalty.read more The borrowers get the flexibility to either foreclose the loan or make part repayment anytime. If they close the loan before time, they have to pay interest only for the period borrowed. In such a scenario, the borrowers save the interest for the remaining period.

Examples

Let us understand the concept of DL using examples given below:

Example #1

A small American farmer, McMahan, setups a modern dairy plant in his village. To fund its short-term operational needs, he plans to take a loan. But, with no credit history to flaunt, if the farmer goes to the bank and asks for a working capital loanWorking Capital LoanA working capital loan is a loan taken out by a company to finance its day-to-day operations, such as funds to cover the company’s operational needs for a short period of time, such as debt payments, rents, or payroll, rather than for long-term investments or assets.read more, the farmer is not likely to get it.

But if McMahan can provide collateral like a fixed deposit or insurance paper, the farmer can easily avail the DL to fund his business activity. The collateral will cover the loan amount and fully secure McMahan’s loan.

Hence, McMahan takes a demand loan against the fixed deposit he has with the bank and gets the required funds to operate the dairy project. Bank will be willing to offer debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more as it can request repayment anytime and receive interest on the money lent. Also, the bank has the option to encash the deposit in case of default.

Example #2

An individual, Martin, has some urgent medical needs and requires some loan for the same, but for a shorter duration. As Martin’s loan needs are urgent, Martin may not like to undertake the lengthy process of loan disbursement from the banks.

Therefore, Martin will hand over the life insurance policy as collateral and avail the DL to cover his treatment. Moreover, Martin can close the loan as soon as he gets the money from his pension fundPension FundA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.read more and pay interest only for the period he borrowed the money. Therefore, he’ll have access to instant funds and pay less interest.

Example #3

Demand Loan vs Term Loan

For knowing the real difference between the DL and term loan, we will study the below table:

The above table shows that DL is the best form of working capital debt for businesses. A favorable DL agreement benefits both the lender as well as the borrower. Also, term loans are more suitable for an individual salaried class person who can easily repay the loan using the EMI option spread over a long period like housing loans.

This has been a Guide to what is Demand Loan and its meaning. Here we discuss the demand loan concept with examples, agreement, & interest rate & compare it with term loan. You may also have a look at the following articles to learn more –

DLs are short-term loans that the lender can call for repayment anytime. They work on the principle of keeping any tangible asset or financial instrument as security against which the lender grants a loan to the borrower. The loan is always given to the extent which can be covered by the value of the collateral in case the loan gets defaulted.

DLs are easily available to the borrower. It can be availed even by clients with bad credit records. It needs less time for disbursal and can be paid in full prior to the loan tenure. Since it is a secured loan, the lender doesn’t face the risk of default. The lender can also benefit from the interest income.

They are generally taken by individuals for immediate personal needs like marriage, education, or medical treatment and by businesses to meet their short-term or working capital needs. Businesses can use them to pay salaries, rent, purchase inventory, machinery and equipment, and invest in new projects.

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