Cash credit vs overdraft vs term loan: choosing the right MSME working capital product
How cash credit, overdraft, working capital demand loans and term loans differ for Indian MSMEs, how limits are sized, what they cost and which suits your cash cycle.
Use a term loan for things that last (machinery, a vehicle, a shop fit-out) and repay it in EMIs over the asset's useful life. Use a cash credit (CC) or overdraft (OD) limit for working capital that rises and falls with your sales cycle: you draw what you need, pay interest only on the amount used for the days used, and repay as customers pay you. A cash credit limit is backed by your stock and receivables and capped by a monthly drawing power; an overdraft is usually backed by property, deposits or simply your cash flows. Funding stock with a five-year term loan, or a machine with an overdraft that must be renewed every year, is one of the most common and costly MSME mistakes.
This guide belongs to the MSME business loan interest rates overview. Figures are illustrative.
The main products side by side
| Product | How it works | Interest charged on | Renewal | Best for |
|---|---|---|---|---|
| Term loan | Lump sum, fixed repayment schedule (EMI or structured instalments) | Outstanding principal | None; runs to maturity | Capital assets, long-term expansion |
| Cash credit | Revolving limit against hypothecation of stock and book debts; withdrawals limited by drawing power | Daily outstanding balance, debited monthly | Annual review | Manufacturers and traders with inventory and receivables |
| Overdraft | Revolving limit, against property, fixed deposits or cash flow | Daily outstanding balance | Annual review | Service businesses, irregular cash needs |
| Working capital demand loan (WCDL) | Short-term loan carved out of the working capital limit, often for a fixed period | Amount drawn | Rolled over | Larger borrowers wanting a lower rate for a fixed portion |
| Bill or invoice discounting | Lender advances against a specific bill or invoice | Amount advanced, for the bill period | Per bill | Receivables from creditworthy buyers; see TReDS |
| Letter of credit / bank guarantee | Non-fund-based limits | Commission, not interest | Annual | Import, supply contracts, tenders |
Worked example: why the product matters
An illustrative trader needs extra stock of ₹30 lakh for four months each year (festive season) and almost nothing for the rest of the year.
Option A: ₹30 lakh term loan, 5 years at 11%. EMI ₹65,227 for 60 months; total interest ₹9,13,636. The trader pays interest all year on money that is idle for eight months, unless he parks it in a low-yield deposit.
Option B: ₹30 lakh cash credit limit at 10.5%. Suppose the limit is fully used for four months and unused for eight. Interest ≈ ₹30,00,000 × 10.5% × 120 ÷ 365 ≈ ₹1,03,562 a year, plus annual renewal and inspection charges. Over five years that is about ₹5.2 lakh, before fees, and the trader repays the limit each season from sales.
The cash credit is cheaper here because interest follows usage. For the exact daily-balance and drawing power method, see the cash credit interest and drawing power guide.
How banks size a working capital limit
Banks use one of these approaches, depending on the size of the limit:
- Turnover method. For smaller MSE borrowers, RBI's MSME lending directions ask banks to assess fund-based working capital limits of up to ₹5 crore at a minimum of 20% of projected annual turnover, with the borrower bringing 5% of turnover as margin. For example, projected turnover of ₹1.5 crore implies an assessed requirement of about ₹30 lakh. Check the current directions; banks apply this within their own credit policy.
- Operating cycle / MPBF method. For larger limits, banks look at your holding period of raw materials, work in progress, finished goods and receivables, less trade credit from suppliers, and fund a part of the gap.
- Cash budget. For seasonal or project businesses, a month-by-month cash flow forecast.
Your drawing power each month is then calculated from stock and receivables statements after margins, and you can only draw up to the lower of the sanctioned limit and drawing power.
Costs of a working capital limit beyond interest
- Processing fee at sanction and a renewal fee each year, with GST.
- Stock audit fees for larger limits.
- Insurance of hypothecated stock, a standard condition.
- In some banks, a commitment charge on the unused part of the limit.
- Penal charges if stock statements are submitted late or the account is overdrawn beyond drawing power.
These belong in your comparison. See processing fees and the KFS.
Warning signs that you have the wrong product
- Your CC account is always fully drawn and never comes down. That is core working capital or even capital spending that should be funded by a term loan or your own capital. A permanently over-drawn account can also become "out of order" and slide towards NPA status; see SMA and NPA.
- You are paying a term loan EMI and also keeping the money idle in a current account.
- You bought machinery out of the CC limit, and now drawing power from stock does not support the balance.
- You rely on an overdraft renewal each year for something that will take five years to pay back.
Checklist before you ask for a working capital limit
- Monthly sales and stock levels for the last 12 months, to show the peak and trough.
- Debtors ageing: receivables older than 90 days are often excluded from drawing power.
- Creditors: your suppliers' credit reduces what the bank will fund.
- Projected turnover for next year, consistent with GST filings.
- Your margin (own funds) for working capital.
Frequently asked questions
Is an overdraft cheaper than a cash credit?
Not necessarily. Rates depend on the security. An overdraft against a fixed deposit can be cheap; an unsecured overdraft can be expensive. Compare the rate, the security and the renewal charges.
Can I convert part of my cash credit into a term loan?
Banks often carve out a working capital term loan for the "hard core" part that never revolves, repayable in instalments. It can reduce pressure on drawing power.
Do I pay EMI on a cash credit limit?
No. Interest is debited monthly and must be serviced, and the limit is repaid as your sales are realised, then reviewed annually. Use the business loan EMI calculator only for term loans.
What happens if the bank does not renew my limit?
The bank must give notice, and the outstanding becomes payable as per the agreement. Start renewal well before the due date with updated financials and stock statements.
Sources
- Reserve Bank of India — Lending to MSME Sector directions, working capital assessment and IRAC norms
- SIDBI — MSME working capital information
- Ministry of MSME — schemes for MSMEs
