Business Line of Credit vs. Loan: Which Is Right for Your Business?
Do you understand the difference between a loan and line of credit?
- July 23, 2020
- 5 min read
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Debt financing can give your startup the boost it needs to get off the ground — or it can leave you still underfunded or overextended. Between brick-and-mortar banks and online or alternative lenders, there’s no short of financing options, but they’re not all available to startups. Additionally, one of the first decisions you’ll need to make is whether to take out a business loan or line of credit, which requires a thorough understanding of both options. Find out the differences, as well as the pros and cons of a business line of credit versus a loan to choose the right option for your startup.
A loan is the extension of money in return for a promise to repay the borrowed amount, usually with interest. Interest, which is a fee the lender charges you to use its money, is expressed as a percentage of the loan amount.
A business loan, or term loan, provides funds to start, support or expand a business. The loan is made for a specific amount of money and is repayable over a pre-determined period of time. Term loans are a good option for businesses with predictable long-term expenses.
Many banks and other lenders offer term loans to businesses. And among its many financing programs, the Small Business Administration has a guaranteed business loan. The Standard 7(a) loan encourages lenders to loan money to small businesses by guaranteeing repayment of up to 85 percent of the loan amount — 75% for loans greater than $150,000 — in the event the borrower defaults, according to the SBA. But, it should be noted that you’ll pay a guarantee fee when you close the loan.
A line of credit is like a credit card in that the lender approves you for a specific credit limit, and you withdraw the money as you need it and make payments only on the amount you’ve withdrawn. Lines of credit are a good choice for business owners who need cash now and might need quick access to more in the future since you’ll have continual access to credit as long as you pay down your balance.
As with term loans, lines of credit are available from a variety of banks and other lenders. The SBA also has a business line of credit program, called CAPLines, available for specific uses: contracts, seasonal activities, construction projects or short-term working capital.
Both are loans and lines of credit are types of loans, and as such, they have a lot in common. But because they’re very different financial products, it’s helpful to look at their unique characteristics to evaluate which option is better for your business.
Here are the primary differences in interest rates for both loans and lines of credit:
- Loans: Term loans typically have a fixed interest rate, so your payment stays the same throughout the whole term of the loan and rates don’t change.
- Business lines of credit: Lines of credit on the other hand, often have variable interest rates based on the prime rate, and although interest rates are usually lower for a line of credit versus a loan, your payment might go up or down as your interest rate does. Additionally, some lenders impose a penalty interest rate on accounts with late or missed payments.
When shopping for a loan or line of credit, you’re bound to see the term “annual percentage rate,” also known as APR, mentioned. The APR is expressed as a percentage, and it represents the total annual cost of having a loan. It includes both interest rates and other fees, such as guarantee fees and closing costs that are rolled into the loan.
Term loans are fairly straightforward. You borrow a specific amount of money for a “term” of four, five, six, 10 years — or even longer, in some cases. You’ll make a monthly payment in the same amount — consisting of some of the principal balance plus a fixed interest rate — each month for the entire term of the loan or until it is paid off completely.
Lines of credit work differently. Similar to a credit card, the lender sets a credit limit. You can borrow up to that limit for a predetermined length of time called the draw period. During the draw period, you’ll make principal and interest payments on the amount you’ve borrowed. After the draw period ends, you’ll have a certain period to repay the outstanding balance. The best part, though, is that you can continue borrowing up to your limit as long as you pay off the balance, meaning you can reuse that credit line over and over again to suit your needs. This provides a business with more long-term flexibility than compared to a loan.
You’ll find secured and unsecured options for both loans and lines of credit, but term loans are often secured and lines of credit are often unsecured.
A secured loan is one for which you put up collateral — something of value that you forfeit to the lender if you default on the loan. For example, a car serves as collateral for auto loans and houses serve as collateral for mortgages.
An unsecured loan requires no collateral. Your application is evaluated solely on the strength of your credit. The downside is that unsecured loans are riskier for the lender, so lenders might charge a higher interest rate.
There’s more to shopping for loans than finding the lowest interest rate. Other features to compare include:
- Annual fees sometimes charged for lines of credit
- Down payment requirements for equipment, real estate and franchise purchases
- Prepayment penalties, which are fees for repaying a loan early
- Closing costs
The way you apply for a small business loan is essentially the same way you apply for a line of credit — by providing financial information that might include: credit score, tax returns, financial statements and information such as the length of time you’ve been in business. The lender evaluates your finances and, in most cases, credit history to determine if they should extend a loan to you.
SBA loans require jumping through some additional hoops. You’ll need to submit a business plan and a resume for each principal, for example, and provide personal background and financial statements and give a personal guarantee. Additionally, SBA loans require three years of business tax returns, so they aren’t a reasonable option for startups or fairly new businesses.
Loans and lines of credit both have positive and negative points. Check out the pros and cons of each to decide which option is best for your unique circumstance.
- Ability to finance large expenditures for long periods of time
- Predictable loan payments
- Fixed interest rate
- No flexibility once you’ve borrowed the money
- Often has closing costs such as underwriting and appraisal fees
- Payments start right away, even if you haven’t used the loan money yet
- Borrow only what you need, as you need it
- Reusable, up to the amount of your credit limit, during the draw period
- Potentially lower interest rates than a fixed-rate loan
Related: The Best States to Start a Business
- Shorter repayment terms
- Possibility of penalty interest rate increases if you pay late
- Potentially unpredictable payments make financial planning difficult
In the end, which type of financing is the better choice depends on your goals for your business. Base the decision on how long you need access to cash, your tolerance for loan fees and how important it is to you to know exactly how much you’ll be paying each month of the term of your loan.
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- 10 Tips For Female Entrepreneurs From Female Founders
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Photo credit: LDprod/Shutterstock.com
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