Small Business Line of Credit vs. Term Loan: Understanding the Difference
Whether you’re just getting your business off the ground or you have decades of success in the books, maintaining the bottom line will always an important consideration. Many factors can affect cash flow management, such as seasonal effects, investments in growth, staffing requirements, supply chain changes, vendor relationships and more.
Fortunately, the world of lending is not a one-size-fits-all solution, and there are many options for all types of small business owners.
One high-level decision you’ll have to make is whether a traditional term loan (you borrow a sum of money and repay it on a set schedule) works for your needs or if a business line of credit (an amount of money you can draw from as needed) would be a better fit. Both a line of credit and a term loan from traditional lenders like banks and credit unions both usually require a personal credit score of 680 or above, two years of business operations and $100,000 in revenue. A loan from an alternative lender will typically have more relaxed lending requirements, but higher interest rates.
What is a business line of credit?
A line of credit provides access to a source of cash up to a set limit, which you can draw from when you need it. You pay interest only on what you actually borrow and typically a credit line is revolving, meaning once you repay a portion, you can draw from that money again. Having access to this cash supply can bring peace of mind to business owners, especially those dealing with seasonal financing challenges or cash flow issues related to rapid growth.
Types of credit lines:
- Unsecured lines of credit. These types of credit lines do not require collateral, such as a home or other assets). Business owners who don’t want to put any personal property or assets at risk in case their business fails usually prefer these credit lines. To minimize the risk of default, however, most lenders will require a personal guarantee, which is an agreement that they can sue you for personal assets if you default. Your business revenue and personal credit should be strong if you want to qualify for an unsecured
- Secured credit lines. These credit lines might require a cash deposit — similar to a secured credit card — or a physical asset, like real estate or equipment. Putting up collateral might allow newer business owners or those with less-than-perfect credit scores to secure a better interest rate or receive a bigger credit line.
Is a business line of credit right for you?
One of a credit line’s primary benefits is flexibility. You use the funds as you need them and pay back only the amount you use. You usually won’t have to put up collateral unless the loan is secured, but keep in mind that a line of credit might be more difficult to qualify for.
A line of credit can come with additional costs, such as annual maintenance fees or draw fees (a fee you pay whenever you take money from the line), and the interest rate might be variable, making it more complicated to set a budget. And although the money is readily available once you set up the line, the initial process might take a while.
If your personal and business credit ratings are good and your business has a strong revenue history, you might be a good candidate for a line of credit. This product works for business owners who might not have the liquid cash available for emergencies or those who need a little extra flexibility in their cash flow during slower seasons.
What is a term loan?
You might be more familiar with a term loan because its structure is similar to a mortgage, car or student loan. A lender provides an approved sum of money that you repay over a set period at a predetermined interest rate, which might be fixed or variable.
Types of term loans
Depending on your business scenario, how you’ll be using the money and how much you’ll need, there are a few different term loan options.
- The U.S. Small Business Administration (SBA) is a government entity that works with banks and other lenders to grant funding for American business owners. The SBA partially guarantees these loans — up to 90 percent in some cases. Rates are typically not as competitive as traditional bank loans, but the loan amount tends to be high — up to $5 million — and the terms are longer than others — up to 25 years, in some cases.
- Short-term loans typically get paid back in as few as three months or as many as 18 months and payments might be structured on a daily, weekly or monthly basis. Businesses that face seasonal cash flow challenges or need a small amount of cash might consider this type of loan.
- Long-term loans, on the other hand, can go up to millions of dollars and come with repayment terms as long as 25 years. The more funding you request, the stricter the qualifying requirements will be. Long-term loans might be a good option for businesses interested in purchasing another company, relocating, investing a significant amount of money in research and development or looking to expand.
- Microloans are available from traditional banks, online lenders and the SBA. They are typically small in amount — most are for less than $35,000, although the cap is at $50,000 — and require that you pay them back over a short-term period. A microloan could be a good option for your business if you need only a small amount of cash and can pay it back over a relatively short time period.
Is a business term loan right for you?
Although interest rates on term loans might be more competitive than other funding options, including lines of credit, the approval process can be lengthier and the requirements more requirements. The rate you sign up for is typically fixed — so and won’t change — meaning your scheduled payments will be consistent, too.
A traditional term loan might be a good option for you if your business has a solid history of revenues (at least a couple of years) and your personal credit score is good (680 and above). Much like with a mortgage, the interest will dominate the payments early on, but if you pay a little bit extra here and there it can add up quickly and shorten the repayment period. Just be sure to confirm with your lender that there isn’t a penalty for early repayment.
What’s the difference between a line of credit and term loan?
A good rule of thumb for funding is to use short-term debt to pay for short-term debt and long-term debt to pay for long-term debt. For example, you’d be best to use a business credit card for everyday purchases you can repay quickly, such as office supplies.
A business line of credit is often better for larger expenses that you wouldn’t put on a credit card. A business line of credit is great for seasonal businesses, which might have slow periods throughout the year, but still need to pay for expenses like rent, utilities and employees. A term loan is best for long-term expenses, such as a business expansion or buying a large amount of equipment.
Here’s how a business line of credit and a business term loan stack up:
|Business line of credit vs. term loan|
|Business Line of Credit||Business Term Loan|
|Best for covering short-term cash flow issues||Better for large, long-term expenses|
|Interest rates sometimes variable; usually a lower interest rate than a term loan||Most interest rates typically fixed — might be higher than a line of credit, but payments are spread out|
|Can be secured or unsecured||Often secured by collateral|
|Fewer restrictions on how you use the funds||Restrictive on how you can use the money|
|Pay interest on only on amount borrowed||Principal and interest payments start immediately|
|Usually revolving — access more money when you repay what you’ve borrowed||Funds issued as lump sum|
The bottom line
Depending on your business, credit history, cash flow trends and funding needs, a business line of credit or a term loan are both solid funding solutions for your business. A business line of credit can provide funding when you need it, but you don’t need to use the full amount. A business term loan, on the other hand, gives you a lump sum that you’re obligated to pay back. If you are just starting out and need cash to fund daily expenses, a business credit card might be your best option.