One of the most frequent questions upon which we advise our clients is when to use a business line of credit as opposed to a business term loan. We commonly advise our clients based on the use of funds and rate of return. In other words, what are they doing with the funds and how quickly will that merchant see a return.
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.
The second distinction is in regards to the frequency of draws. A business line of credit, for a merchant in good standing, 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 retains 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 is in regards to 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.
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, if a company is in a growth stage, shorter-term funding would be more appropriate. A great example of a shorter term funding is a business line of credit.
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.
There are many examples when a business line of credit is the most appropriate options. A construction company is just one of many instances where merchants benefit from a business line of credit. In short the factors to look at are, the use of funds, return time on use of funds, the flexibility of use and avoided locking in funding for a long period during stages of growth.