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Updated: Apr 8, 2020
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.
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.
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.
|Business Term Loans||Business Lines of Credit|
|Loan Amount||Ranges from several thousand to over $1M.||Credit limits can range from several thousand to over $500,000. Some lenders have minimum draw requirements.|
|Payments||Start repaying immediately, often with fixed monthly payments.||May be able to make minimum or interest-only payments in the beginning.|
|Repayment Period||Choose your period, which could range from about six months to several years||Can 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%|
|Requirements||You may need an established business with good credit and revenue.||You may need an established business with good credit and revenue.|
|Additional Costs||Lenders 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.|
|Liability||Either 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.|
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.
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.
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:
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.