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Small Business Line of Credit vs. Loan: What’s Best For Your Business?

Business line of credit

Small Business Line of Credit vs. Loan: What’s Best For Your Business?

Updated: April 7th, 2020

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When you started a business, you might not have realized you also signed up to become the chief financial officer. But as a business owner, understanding your funding options and the best uses for different financial products can help you grow your business and survive unexpected setbacks. 

Small business term loans and business lines of credit are two popular options for business owners who need a large amount of financing. The former is often best suited for large projects that have a one-time expense, while the latter can act as emergency funding or help with shorter-term cash flow crunches. 

Here’s an overview comparing business lines of credit vs. loans, including how both types of financing work and the pros and cons of each.

What is a small business term loan?

A term loan is a type of installment loan. When you take out an installment loan, you’ll receive the entire loan amount upfront and then repay the loan over a predetermined period. Generally, you’ll make monthly payments. And, if you have a fixed-rate loan, each payment will be for the same amount. 

Banks, credit unions, and online lenders offer small business term loans with varying requirements, loan amounts, fees, and terms. Small Business Administration (SBA) loans may be installment loans, but you can find faster and easier ways to get a loan as well. 

Sometimes, you may take out a term loan with a specific purpose, such as an equipment financing loan to buy a new piece of machinery. Other terms loans allow you to use the money for almost anything. 

What is a business line of credit?

A business line of credit is a type of revolving credit line. With a line of credit, the lender approves you for a total credit limit, but you don’t need to take out a loan right away. 

You can borrow against the credit line—sometimes called taking a “draw”—as long as your balance doesn’t exceed your credit limit. As a revolving account, you can pay down your balance and take out more draws without reapplying for a new loan. It’s similar to a credit card, but often with a higher credit limit. 

With a business line of credit, you only pay interest on the money you borrow. However, you may have a variable interest rate, and your interest rate (and payments) may arise after you take out a draw. 

In comparing a term loan vs. line of credit, depending on the terms of the credit line, it can be similar to a term loan in that you may have to repay each draw over a specific period. Or, you may be able to make minimum payments during an initial draw phase, such as a three- or five-year period. If your line of credit has a draw phase, you may be able to apply to keep the credit line open at the end. Otherwise, your account enters a repayment phase, you won’t be able to take out any additional draws and you’ll have to pay off the outstanding debt over a specific term. 

A business line of credit vs. a loan: How do the two compare?


Business Term LoansBusiness Lines of Credit
Loan AmountRanges from several thousand to over $1M.Credit limits can range from several thousand to over $500,000. Some lenders have minimum draw requirements.
PaymentsStart repaying immediately, often with fixed monthly payments.May be able to make minimum or interest-only payments in the beginning.
Repayment PeriodChoose your period, which could range from about six months to several yearsCan depend on your draw amount, minimum payments, and whether you renew the credit line
Annual Percentage Rate (APR)Often fixed rates ranging from around 5% to 35%Often variable rates ranging from around 7% to 25% 
RequirementsYou may need an established business with good credit and revenue. You may need an established business with good credit and revenue. 
Additional CostsLenders may charge origination, application, administrative, prepayment, and late payment fees. Lenders may charge application, monthly, and annual account fees. You may also have to pay an origination fee on draws, and prepayment or late payment fees.
LiabilityEither a secured or unsecured account. You may also have to sign a personal guarantee.  Either a secured or unsecured account. You may also have to sign a personal guarantee. 

What are the benefits and drawbacks of term loans?

Pros

  • You’ll immediately receive the entire loan 
  • A predictable repayment amount and period makes it easier to budget 
  • Some lenders don’t charge many fees
  • Potentially low-interest rates based on your business’ qualifications 

Cons

  • You might not get approved for all the funding you need
  • Additional funding requires a new application
  • Some lenders charge lots of fees
  • You may have to offer collateral and sign a personal guarantee

What are the benefits and drawbacks of business lines of credit?

Pros

  • Easy access to funding once you get approved for a credit line
  • Only pay interest on the money you borrow
  • Borrow against the same credit line multiple times
  • May offer higher credit limits and lower interest rates than credit cards

Cons

  • Could have a variable interest rate that applies to all balances
  • Lenders could charge you monthly or annual fees
  • Might require an annual review to keep the account open
  • You may have to offer collateral and sign a personal guarantee

When is it best to use: Business line of credit vs. business loan?

Each small business financing option has its best use-case, even if it’s as a last resort. Both term loans and lines of credit are conventional forms of business financing that small business owners have relied on for years. However, business owners often use these types of finding for different sorts of projects. 

When comparing term loans vs. a line of credit, term loans are best when:

  • You need a lot of funding: You may be able to borrow a lot of money with a term loan. Business owners may take out term loans when they want to expand their business, buy a competitor, or ramp up for a surge in orders.
  • You want a long repayment period: Cash flow is often an issue for small businesses. Applying for a term loan with a more extended repayment period can lead to lower monthly payments and minimize the impact on your cash flow. With a fixed-rate term loan, you also don’t have to worry about rising interest rates like you may have to with a variable-rate line of credit. 
  • You’re paying down high-rate debt: While taking out a term loan to fund a new project might be the most compelling reason, a term loan can also serve a purely financial purpose. If you’re struggling with high-rate debt, such as business credit card balances, you may be able to use a term loan to consolidate the debts and decrease your interest rate. 
  • You have a profitable plan: Borrowing money without a thought-out plan can jeopardize your business. While business owners customarily take risks, make sure you can put the money you borrow into action and get a positive return on investment.

A line of credit is best when:

  • You want a safety net: You can keep your credit line open without taking any draws and won’t have to pay any interest. Some lenders charge monthly or annual fees, but you can sometimes find fee-free options or ask for fee waivers. With your credit line available, you’ll know you have access to funding if an emergency arises. 
  • You have regular, short-term financing needs: As revolving accounts, both credit cards and business lines of credit give you continual access to financing without submitting new applications. However, in comparing a small business loan vs. a line of credit, a  credit card can be a better option if you only need a small amount of financing and can then pay your bill in full to avoid interest. However, business lines of credit may offer a higher credit limit and lower interest rate, which makes them a better fit if you regularly borrow large amounts and take several months to pay off the debt. 
  • You need financing for an ongoing project: Because you only pay interest on the money you borrow, a business line of credit can also work well with ongoing projects. Perhaps you have a six-month marketing plan or hire a contractor and have to make progress payments. Rather than taking out a term loan and paying interest on everything, you can borrow what you need—when you need it—with a line of credit. 

How do term loans complement lines of credit? 

Terms loans are best for significant and long-term financing needs. Comparatively, you’re best using a line of credit for ongoing operational or emergency expenses. As a result, it’s no longer a debate of a business line of credit vs. a loan. Instead, many business owners may find themselves opening both types of accounts at some point. 

For example, say you run a manufacturing business that designs and builds holiday toys. You know expenses will start to ramp up as the busy season approaches, but it may be several months before you see any income from your efforts. Even if you can borrow enough money to cover all your busy-season expenses, with a term loan, you’d have to pay interest on everything from the start. 

Instead, you take out a business term loan to pay your upfront expenses for supplies, recruiting, and training. You complement this with a line of credit, which you can draw against to make payroll and pay for shipping. 

You can arrange both types of financing to fit your business’ finances. Perhaps you choose to pay off the term loan over six to 12 months, and knock out the line of credit draws as soon as you receive payments for the toys you sold. 

What should you look for in a small business lender?

So, let’s say you compared a term loan vs. a line of credit and decided that you are in a situation that calls for a small business term loan. Now, you’ll want to continue your research and due diligence to find the best lender for your situation. As you compare your options, ask yourself: 

  • Do you need the money right away? An online lender can often offer a streamlined application and approval process, getting money into your account within a day. Traditional banks and Small Business Administration (SBA) lenders may offer lower rates, but you may have to put in more work to complete the application and then wait weeks or months to receive the loan. 
  • How much do I need to borrow? Lenders will often list their loan amount ranges online, helping you narrow down your list of potential lenders based on how much (or little) you need to borrow. However, you may get approved for less than you apply for depending on your business’ creditworthiness
  • Interest rate ranges and types: Also, look at the interest rate ranges, keeping in mind that your rate depends on your business’ finances and creditworthiness. If you want a predictable payment, make sure the lender offers fixed interest rates. A variable-rate may be lower at first, but you risk the rate and your payment increasing in the future. 
  • How long do I need to repay the loan? Given the same loan amount and interest rate, a longer repayment period means paying more interest but lower monthly payments. Find a lender that offers a repayment term that won’t impose on your cash flow. 
  • What fees will I pay? Lenders may charge a variety of fees, including an application or origination fee, and another fee if you repay the loan early. Shop around, and you may find lenders that don’t charge many fees. 

As you compare lenders, you can compile a shortlist of the best potential fits. Then, apply for financing and accept the offer that aligns with your business’ needs and capabilities.

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