How A Business Loan is Different from a Line of Credit
As its name suggests, term loans are paid back within a predetermined 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 may keep the loaned amount for as long as you need it—assuming you continue to pay interest on the debt.
With a line of credit, your monthly payments depend on the amount you have currently borrowed. If you have no need for debt at the moment, your expenses on the line of credit are zero. You can choose to draw cash as needed, up to the limit of your credit line. With a term loan, you are given the entire principal upfront and pay interest on the debt until it is returned.
Both term loans and lines of credit can be secured or unsecured. Security for a term loan is typically an asset, such as property. Collateral for a line of credit might often be an intangible such as accounts receivables.
There are numerous ways to customize your debt within either structure. For example, there are interest-only term loans in which you pay only the interest throughout the loan term and return the principal at the end. You might prefer this option for 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. It is important to speak to the lending institution you are borrowing from, and understand the options available to you.
Fees and Cost
To qualify for either type of financing, you will typically be charged a processing fee and a credit check fee. If your business loan is backed by collateral, you may also be charged an appraisal fee for the asset. However, going forward, you will only be expected to make your monthly payments on interest and principal, and possibly late fees for missing a deadline.
Lines of credit, on the other hand, typically charge a transaction fee every time you make a withdrawal against your line, in addition to interest payments. Monthly interest payments are only on outstanding debt, and not the total credit line. They may also be interest-only payments, or interest and a portion of the principal.
While most term loans use a straightforward, fixed rate of interest, lines of credit are typically structured with variable interest rates adjusted to some benchmark, index, or another factor, such as the prime lending rate. Variable rates can go both ways. If you use your revolving credit responsibly and make prompt payments, your interest rates may be lower than with a term loan. Missing payments, however, can also skyrocket your rates and hamper access to capital, or at least make it more expensive.
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 risk for the lender and mean a low, and consistent, interest rate for you. Regular payments on the loan can also be factored into your operating expenses. Term loans typically require payment within a few years if unsecured, but can extend much longer with collateral.
Almost all businesses can benefit from a line of credit to cover sudden gaps in cash flow. For example, you may use it to temporarily cover operating expenses until you are paid by the customer. A good measure of whether to use your line of credit is if the expense you are using it for will generate sufficient revenue in the short-term to pay back quickly. Credit lines can be structured to extend for several years. However, in some cases lenders have the option to “call the line” and demand repayment – if your credit risk profile changes, or for no reason at all.
Which Industries Benefit
Industries with seasonal revenues, such as retail, would benefit the most from a credit line – which can be used to purchases supplies or maximize inventory ahead of prime selling times. The proceeds can then be used to pay back the principal and bring your revolving credit back to zero. Term loans, on the other hand, favor companies that require large capital investments – like the construction industry. Established firms with sound financial history can secure lower interest rates, especially if they can afford large down payments on the asset.
For startups that lack regular cash flow, a revolving credit line can be a ballast to keep operations running smoothly. However, even established companies may benefit from emergency access to cash to cover unexpected setbacks, such as equipment breaking down, or overdue accounts receivables.
You can apply for either type of credit with financial institutions like banks and credit unions, in addition to alternative lenders. It may help to go with a lender that you have a history with, that may be more likely to extend you credit. Credit lines through traditional banks tend to be harder for unestablished businesses than online lenders. However, you can apply for your loan to be backed by the U.S. Small Business Administration.
The application for either type of debt is similar. The lending institution will want to see as much information and history as you can provide – including financial statements, tax returns, revenue projections, and even your personal resume.
Keep in mind that you are more likely to be denied for term loans than revolving credit lines, which are bigger and more complicated transactions. This is because they also pose more risk for the lending institution. If you or your business do not have established credit, using a line of credit responsibly may help you build credit to qualify for a business loan. Loan applications can also be drawn out, which makes it unsuitable for quick and short-term cash needs.
How you attain additional working capital can matter as much as how you use it. It is important before approaching a lending institution for financing to understand the options available to you, and assess the needs of your business to minimize cost and maximize profits.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.