How a Business Loan is Different from a Line of Credit

At some point in your business, you might need financing to grow. Where capital comes from can affect your business’s prospects and is not a decision to be taken lightly. Two of the most common forms of financing are business loans and lines of credit. We will explain the differences between these two products so that you can determine if either of them is the right option for your business.

Important Differences

Term loans are paid back within a predetermines period. A line of credit is more comparable to a credit card, which offers an allowance of debt to draw against. The benefit of a line of credit is that you might keep the loaned amount for as long as you need it assuming you continue to pay interest on the debt.

Your monthly payments depend on the amount you have borrowed with a line of credit. If you have no need for debt at the moment, your expenses on the line of credit are zero. You can draw cash as needed, up to the limit of your credit line. A term loan gives you the entire principal upfront and pay interest on the debt until it is returned.

Term loans and lines of credit are either secured or unsecured. Security for a term loan is typically an asset, such as a property. Collateral for a line of credit might be intangible such as accounts receivable.

Debt Structure

There are many ways to customize your debt within either structure. You can pay only interest throughout the loan term and return the principal at the end with interest-only term loans. You might prefer these options due to tax reasons or if you expect freeing up cash in the short term will generate enough revenue to return the principal in full at a later date.

Fees and Cost

To qualify for either financing type, you will be charged a processing fee and a credit check fee. If your business is backed by collateral, you might be charged an appraisal fee for the asset. You will be required to make your monthly payments on interest and principal, and possibly late fees for missing a deadline.

Lines of credit on the other hand charge a transaction fee every time you make a withdrawal against your line, in addition to interest payments. Monthly interest payments are on outstanding debt and not the total credit line. There might be interest-only payments or interest and a portion of the principal.

Lines of credit are structured with variable interest rates. If you use your line of credit responsibly and make prompt payments your interest rates might be lower than with a term loan. If you miss payments, it can skyrocket your rates and make it more expensive.

Best Uses

Term loans are best for financing large purchases such as equipment or real estate that you do not expect to pay off quickly. The asset can be pledged as collateral which minimizes the risk for the lender and consistent interest rate for you. Term loans typically require payment within a few years if unsecured but can extend longer with collateral.

Industries That Benefit

Industries with seasonal revenues would benefit the most from a credit line which can be used to purchase supplies or increase inventory. Term loans favor companies that require large capital investments such as the construction industry. Established companies with good financial history can secure lower interest rates, especially if they can afford large down payments on the asset.

The Bottom Line

How you attain working capital can matter as much as how you use it. It is important that you understand the options that are available to you and assess the needs of your business to minimize cost and maximize profits.