If you’re seeking capital to run and grow your small business, you may be debating between a line of credit and a term loan. But how do these two small business loans work, and in what situation should you apply for each one? Here’s a closer look:
Business line of credit: A business line of credit is similar to personal lines of credit, such as credit cards or home equity lines of credit. You have access to a specific amount of financing—say, $50,000—but you don’t make payments or incur any interest until you tap into the funds.
Lines of credit can be secured or unsecured business loans (typically by inventory or receivables). They are often referred to as “revolving,” which means you can tap into them again and again. For instance, if you have a $50,000 line of credit and take out $25,000, you still have access to the remaining $25,000. If you make payments on that $25,000 until it is back down to $0, you still have access to the entire $50,000 without reapplying. It’s very similar to carrying a credit card with a certain limit. Once it is paid down, you can charge more items on your credit card.
A line of credit typically has a lower interest rate and closing costs than a loan of comparable size. However, if you’re late with a payment or go over your borrowing limit, your line of credit interest rate may increase substantially—unlike a term loan, where the interest rate stays the same for the life of the loan.
Term loan: With a business term loan, you borrow a lump sum of money, get it all at once and pay it back over a specific time period (or “term”)—it can range from a year to 20 years. Unlike lines of credit that are typically renewed every 1 – 2 years, a term loan is fixed for the specified amortization period. Lenders prefer loans to be collateralized, but there are options for unsecured loan terms notes and startup business loans with no collateral.
You can select term loans with different repayment periods and with a fixed rate or variable interest rates. (Learn all the details about rates on term loan with a term loan calculator.) However, the borrower must begin repaying the loan immediately (even if you don’t use the money right away). Closing costs and interest rates for term loans are typically higher than those on a business line of credit. And, unlike a revolving line of credit, once you use up all the loan funds, you’ll need to reapply for a new loan in whatever lump sum amount your business needs at that time.
Now that you understand how these financing options work, when should you choose a business line of credit as opposed to a term loan?
Term loan: Term loans are the kind of business loans work best for long-term investments. For instance, if you’re buying capital equipment or other fixed assets that will take several years to pay off, buying a business or doing construction, borrowing a lump sum of cash through a term loan is your best bet.
In addition, term loans are typically used for a specific purpose: Much like a personal loan, in order to get the loan, you’ll need to show exactly why you need to borrow the money (what you plan to use the money for and how that will help your business increase sales and profits). If your financial projections convince lenders that these changes will increase your sales and profits, the lender will feel confident that your business will be able to make the repayment.
Here are some situations where you might use a term loan:
- You own a pizza restaurant and want to expand into a larger space that just became available next door. You also want to add two wood-burning pizza ovens so you can serve upscale, Neapolitan-style pizzas (and charge more). The expansion and shift in positioning will take a while to pay off, and the pizza ovens have a usable life of 10 years. Therefore, it’s to your advantage to stretch out the repayment to a long-term loan of 10 years.
- You own a graphic design business and need to buy new computers for your staff of 30. Typically computers have a life of about three years, so a three-year term loan would be appropriate.
The longer you’ve been in business, the easier it will be to get a term loan, as banks want to see a track record of success.
Business line of credit: A business equity line of credit is sometimes called an operating line of credit, because its purpose is to help finance ongoing operating expenses. Think of a line of credit, whether a secured or unsecured loan, as an insurance policy providing a cushion of cash when you need it. That’s why the best time to apply for a business line of credit as a borrower is before you need it—in order to get an unsecured line of credit, you need to prove that your business has healthy cash flow.
Business lines of credit are best for short-term financing needs, such as payroll, seasonal expenses, unexpected payments or temporary cash flow shortages. Missed payments on a line of credit can result in a significant increase in the interest rate. Here are some situations where you might use a line of credit:
- You own a landscaping business and have just completed several projects. You have a huge chunk of receivables due in a week—but you need to make payroll for your 20 employees in two days, and don’t have the cash on hand. You could use the line of credit to cover payroll, then pay it back as soon as your receivables come in.
- You own a business selling fashion accessories from a kiosk, and a particular style of sunglasses is selling like crazy. You need to order more and your supplier is offering a great deal, but requires C.O.D. Use the line of credit to pay for the sunglasses, then pay it back as you sell them.
Be sure not to tie up your business equity line of credit paying for long-term investments, or you won’t have access to it in an emergency, limiting your flexibility—which is the whole point of a line of credit.
Working with a company that’s experienced in matching businesses with financing sources can ensure that you find the perfect type of small business loan for you.