Line of Credit vs Term Loans: Which is Right for Your Business
Ezra Cabrera | February 6, 2023
A smart small business owner knows that building a solid financing plan is vital to the company’s success. With that, they may start looking for different financing options most suitable for them. While many options are available, two excellent sources to consider when going over financing opportunities are business lines of credit and term loans.
This article will cover the costs and benefits, best uses, and qualifications of business lines of credit and term loans. By comparing the two, you will clearly understand which options will work best for you and your small business.
A line of credit is a flexible financing option that provides access to a pre-approved amount of funds that can be used as needed, with interest charged only on the withdrawn funds.
Term loans are a lump sum of money that must be repaid over a set period, with regular payments of both principal and interest.
A business line of credit typically has more flexible repayment terms than term loans, since you only need to repay what you’ve withdrawn, plus interest. On the other hand, term loans have set repayment schedules with fixed payments.
What is a Business Line of Credit?
A business line of credit (LOC) is a financing option that business owners can use on an as-needed basis. It works a lot like a credit card because it has a limit, and the business can use it to pay for short-term business expenses (i.e., short-term cash flow gaps, day-to-day expenses, contingency funds, etc.).
When you apply for a line of credit, the lenders will determine the terms based on your financial and credit profile. The better your business’s credentials are, the better your loan’s terms and credit limit will be.
Business lines of credit are revolving credit, which means that once you repay the money you have used in full, the amount available on your credit line resets, and you can draw from it again. You can withdraw any amount from your credit line at any time as long as you don’t exhaust your credit limit, and you can use that money for whatever you want with no restrictions as long as it’s business-related.
Pros and Cons of a Business Line of Credit
A business line of credit has its share of pros and cons, so let’s look at both sides and see if a line of credit is better than a business loan:
Spending flexibility. With a business line of credit, you can choose where you spend the additional capital – for inventory, bridging temporary cash flow gaps, or addressing unforeseen expenses. There’s no limit to how you can use the cash.
Continuous access to additional capital. Businesses often experience gaps in their cash flow, especially during slower seasons. They may also encounter time-sensitive business deals, like discounted prices on bulk orders. Without a boost in their capital, they won’t be able to take advantage of these opportunities or address cash flow issues as needed.
You only pay for what you use. Unlike a typical business loan, a line of credit allows you to pay interest on the amount you’ve drawn. For example, if you have a line of credit of $10,000 and used $2,000, you’ll only be obliged to pay interest on the $2,000 you consumed.
Improve credit rating. Aside from additional working capital, a line of credit can also help businesses improve their credit rating, given that they make the minimum payment on time and don’t exceed the set credit limit. This is beneficial for young companies in building their business credit.
- Short repayment terms. Short term line of credit provides borrowers with a specified amount of money, which they can access as needed and repay within a relatively short period, typically within a year. This means that the borrower can repay the loan quicker and move on from their financial obligation.
Charges may add up. Lenders may charge several fees to your account throughout the lifespan of your line of credit. Some of the costs you can expect are maintenance fees, draw fees, prepayment fees, origination fees, early termination fees, and late payment fees, closing costs, among others. As you shop for a lender, ask candidates how much they charge for these.
High possibility of overuse. With easy access to cash, it can be tempting to use your line of credit for every business expense. But if you’re not careful, you could end up with an enormous debt, which can quickly become challenging to manage. It’s worth noting that although you can draw from your line of credit anytime, you have to make sure that you’re spending the money responsibly.
Lower borrowing limit. Loan amounts for a line of credit typically range from $5,000 to $250,000. Although it can cover specific business initiatives like marketing strategies or inventory reordering, if you’re planning to fund a bigger business initiative like opening another branch, you might have to consider other financing options (i.e., long-term loans).
When to Use a Business Line of Credit (LOC)
A line of credit gives business owners access to a fixed amount of credit that business owners can access whenever the need arises. They can use it to address short-term needs, such as:
Covering short-term cash shortages
Paying for seasonal expenses
Qualifications for Business Line of Credit
As with other financing options, the better your financial and credit profile is, the higher your chances of getting a favorable term for a line of credit. That said, here are the qualifications that lenders typically require:
A credit score of at least 680
$100,000 or higher in annual revenue
At least two years of business history
Collateral or a personal guarantee
Suppose your business doesn’t meet some of the qualifications mentioned above. In that case, you may still be able to apply for an unsecured line of credit from online lenders and other FinTech companies. These financing institutions may be more willing to take on the risk associated with younger businesses.
Some online lenders may still grant a LOC to businesses with a business history as young as six months, annual revenue of less than $100,000, and poor credit history. However, lenders may charge higher interest rates and fees to mitigate the risk.
What is a Term Loan?
Term loans are a straightforward business financing resource where business owners receive a lump sum upfront. They repay the loan in fixed payments (plus interest) over a predetermined period or term. Lenders usually base the loan amount, repayment term, and interest rate on the business’s financial and credit records.
A small business term loan usually come in three forms: Short-term, medium-term, and long-term loans. Each term loan classification is based on the financing's repayment term. Here’s how each of the term loans works:
Short-term loan. Short-term loans have a repayment period of six months to a year and provide the least amount of funds among the three types – usually $2,500 to $50,000.
Medium-term loan. With a medium-term loan, businesses can receive anything from $50,000 to $500,000, which they can repay within two to five years.
Long-term loan. Long-term loans provide the most funding among the three. With one, businesses can get as much as $5 million, and the loan matures within 10 to 25 years. It’s also the most affordable term loan, as lenders will typically charge a lower interest rate than the other types because of the length of the commitment.
Unlike lines of credit, term loans are non-revolving credit, which means that once the borrower pays the loan in full, they won’t be able to draw credit from it again, and the contract will reach its end. This makes term loans the most viable choice for one-time business expenses.
Pros and Cons of Term Loans
There are a few benefits and drawbacks to term loans. Here are some of them:
Higher funding amount. With a term loan, you can get a funding amount as high as $5 million. This makes it a perfect financing option if you’re looking to spend big bucks on investments such as opening another branch or acquiring a business.
Extended repayment terms. Except for short-term loans, the repayment period (for medium- and long-term loans) can range from two to 25 years. With extended repayment periods, lenders can offer lower repayment amounts to borrowers. This makes it less of a burden to businesses as they won’t have to pay a significant amount each month towards loan repayments.
Lower interest rate. Again, except for short-term loans, medium- and long-term loans generally have lower interest rates (especially long-term loans). Since it’s a long-term commitment, lenders usually charge a lower interest rate (typically 5.25% to 7.75%). The interest rates could even be lower if you apply from a bank or credit union.
Difficult to qualify for. Lenders often require solid borrower credit histories when it comes to term loans. In other words, qualifying for one might be more challenging for newer, smaller businesses or companies with lower credit scores. Underwriting may also be based on the cash flow of your business, if you don't have strong financials or strong credit, you might not be able to qualify.
Higher credit requirement. Since lenders offer higher loan amounts at lower interest rates, they want to make sure they’re getting into an agreement with borrowers who can pay back in time. This means looking at the borrower’s financial and credit records. Ideally, businesses should show a strong flow of revenue and an excellent credit score of 680 or higher. These requirements will be more challenging for newer companies that haven’t been operating long enough to build a substantial credit history.
Collateral is almost always required. Extending credit to small businesses is considered a risky endeavor. Lenders may require collateral (equipment, real estate, inventory, etc.) as security if the company cannot pay the loan back. Other businesses, especially new ones, might not have accumulated enough assets to pledge as collateral. In that case, they may have lower chances of qualifying for a term loan, especially long-term loans.
When to Use Term Loans
The best use for term loans will depend on the type you’re applying for. Let’s look at some situations where each type of term loan may be helpful:
Business owners primarily apply for a short-term loan to address short-term business needs such as:
Store or office remodeling
Temporary cash flow shortages
The primary uses for medium-term loans include:
Business space renovations
Long-term loans usually offer the highest loan amount and are best used towards addressing long-term business initiatives like:
- Opening another branch
- Setting up additional warehouses
- Starting another business
- Business acquisitions
How to Qualify for a Term Loan
Both traditional and alternative lenders offer term loans to small businesses. Most of the time, they require firms to present strong financials and creditworthiness. To qualify for a term loan, the company should have the following:
A credit score of 680 or higher
Annual revenue of at least $300,000
Collateral (it could be personal or business assets such as real estate, vehicles, or machinery and equipment)
Essentially, the better your qualifications, the higher your chances are of qualifying for term loans.
Comparing Term Loan vs Line of Credit
Business lines of credit vs. term loan are just a couple of the many financing options available for small business owners. Typically, a business line of credit will have a higher interest rate than multi-year term loans. But, term loans are generally better for larger purchases or high-ticket items that will take a while to pay off, and qualifications might be stricter than lines of credit. When making funding decisions, it’s essential to consider the different opportunities and understand the costs and benefits of each.