When looking to pursue financing for your small business, you may come across two popular options which are term loans and lines of credit. Both are used to borrow money to pay for purchases and expenses, however they both serve different uses and fit different financing needs, so it is important to know how both of these financing options work.
Term Loans Explained
A term loan, or a business loan, provides funds for businesses to start or expand. It is made for a specific amount of money and repaid over a pre-determined period of time. The period is usually between a few months and 10 years and the payments are monthly, bi-monthly, weekly, or daily payments. Term loans are a good option for those businesses who have predictable long-term expenses. They might have a fixed interest rate or a variable one depending on the lender.
If your business needs financing for the following reasons, a term loan will suit your business:
- Opening a new location – if you are looking to expand your business and open up in a new location, a term loan is a great option to amortize the investment over a period of time meaning each payment will be the same amount.
- Hiring new team members – a term loan is a way great to bring new team members on and can provide a cash cushion to manage increased payroll.
- Renovations and capital improvements – renovating your business can be costly and have a long-term impact on your business. With a term loan you will be able to have the cash up front needed for any business improvements.
You need to be able to show why you need to borrow the money and the exact plan to use the funds for and how it will help our business increase its sales and profits. By doing this, the lender will feel confident that your business will be able to make the repayment.
Term Loan Requirements
Both banks and alternative lenders offer term loans and you need to have a strong business profile to qualify. You need at least three years of business history, a credit score of 680 or higher, and an annual business revenue of $300,000 or higher. The better your business profile looks, the higher loan amount, longer repayment terms, and lower interest rates you will receive.
You also will most likely be asked to provide collateral so the lender can make sure they can get the money if you default on the loan.
Lines of Credit Explained
A line of credit works differently than a term loan. If you need to access capital quickly, lines of credit will be a good fit for your business. This type of loan is paid back over a short period of time and businesses have a source of capital to draw upon. A line of credit is a revolving account which means you draw and spend money up to a certain limit, repay the amount with interest, and then spend it over and over again. Many businesses use a line of credit for unexpected emergencies or opportunities that arise that need to be addressed quickly. The most common type of a line credit is a credit card and home equity lines of credit (HELOC).
Unlike term loans, lines of credit can be used for any purchase such as everyday purchases, to small renovations, to paying down debt. Lines of credit tend to have higher interest rates and smaller minimum payment amounts than loans. Payments include both principal and interest and need to be paid monthly. They also create a large impact on your credit report and credit score.
If your business needs financing for the following reasons, a line of credit will suit your business:
- Cash flow management – with a line of credit, a business can drown on the line and pay its vendors and pay down the line when it is paid by its customers.
- Seasonality – businesses that have slow months and need some extra cash flow to keep it going could use a line of credit. Once the slow month passes, the line can be paid down as the busier months come around.
- Inventory purchases – businesses need to replenish their inventory several times throughout the year. When the inventory is sold, a business can pay the line of credit down with the funds.
Line of Credit Requirements
A line of credit has less strict requirements compared to term loans. Lenders want to see at least one year of business history, a credit score of at least 630 and an annual business revenue of $180,000 or higher.
Lines of credit can be secured meaning they are backed by collateral or they can be unsecured and backed by a personal guarantee.
Which Type of Loan Do You Get?
Before applying for a term loan or a line of credit, it is important that you consider how much financing you will need in the both the long term and the short term, as well as the condition of your credit to help you make the best decision. If you need a lump sum and can pay the money back over a few years, a term loan would be best. If your needs are more vague and you are able to repay the loan quickly, a line of credit is the way to go.