When owners are considering acquiring funding for their small business, they (hopefully) research and consider a variety of lending options. As they go about this process, they will likely come across business lines of credit and business term loans. They might be wondering which option they should choose out of the two. It depends on what they are looking for and how they will be able to pay the lender back. In other words, what are they doing with the funds and how quickly will that merchant see a return?
Business Line of Credit vs. Term Loan
With a business line of credit, you get access to a pool of funds which you can draw from whenever you need capital. Unlike a traditional business loan, you have the flexibility to borrow up to a certain, set amount (typically anywhere from $50,000 to $500,000). Then you repay only the amount you withdrew, along with interest. Business lines of credit are conveniently available whenever needed, so you can use it to handle gaps in cash flow, get more working capital, or address almost any other emergency or opportunity.
Term loans offer a straightforward, affordable funding solution for small businesses. A traditional business term loan is a lump sum of capital that you pay back with regular repayments at a fixed interest rate. The set repayment term length will typically be one to five years long. Most business owners use the proceeds of term loans to finance a specific, one-time investment for their small business. It’s important to note that these will be slightly more difficult to qualify for than lines of credit.
When to use a business line of credit as opposed to a business term loan
The first step is understanding the difference between the two financial instruments. A business line of credit differs from a business term loan in several key factors. First, a business line of credit allows the merchant only to borrow what they need for as long as they need the funds. In other words, if the merchant only needs the funds for ten days, they will only pay ten days’ worth of interest with a complete principal payback. A business term loan is better for longer-term expenses and usually has longer loan terms.
The second distinction is regarding the frequency of draws. For a merchant in good standing, a business line of credit allows that merchant to draw as frequently as needed. For example, if the merchant draws $10,000 today, then decides 48 hours later that an additional $3,000 is required, the merchant has that flexibility. Unlike a business term loan, the merchant does not have to pay back a specific percentage of the funding to be eligible for additional funding.
A similar distinction concerns the payback structure. With a term loan, funds do not become available as the principal balance is reduced. With a business line of credit, there is no waiting period. As soon as payment is applied and the principal is thus reduced, the merchant can borrow those funds again. This makes it great for quick or unexpected expenses that can arise.
Given these factors, we can see when each product would be appropriate. A business term loan is an excellent product for longer-term investments where a company has reached or is about to enter peak growth. On the other hand, shorter-term funding would be more appropriate if a company is in a growth stage. For example, a term loan would be a good idea for a burger restaurant that wants to remodel its interior and buy an additional griddle.
More simply put, a business line of credit is the best financial product when a company has a more frequent use. A great example is a construction company with overlapping jobs. Most projects will be completed with payment received in 90 to 180 days; however, most construction companies will manage multiple projects at a time. A business line of credit will allow the construction company to take several draws as each product starts. The line of credit will also allow the constructions company to pay-off or pay down the balance once payment is received for a project. The flexibility of the line will enable the construction to pick up supplies as needed and save on interest.
The Bottom Line
There are many examples when a business line of credit is the most appropriate option, just as there are with business term loans. A construction company working multiple, overlapping projects is just one of many instances where merchants benefit from a business line of credit. A burger joint starting remodeling and needing another grill is also one of many instances where business owners might benefit from a term loan. Overall, the important things to consider are the use of funds, return time on the use of funds, the flexibility of their use, and choosing whichever option is best for growth and timeline.
Crestmont Capital offers both business term loans and business lines of credit. We also approve 95 percent of our applicants! Click here to learn more about our business lending options. You can also contact us if you’re interested or have any questions.