Line of Credit vs. Term Loans

Ezra Cabrera

November 6, 2018
small business line of credit

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 there are virtually a lot of options available, two excellent sources to consider when going over financing opportunities are business lines of credit and term loans.

Although these business loan options provide the same benefits – additional working capital – these two choices work differently. 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 have a clear idea regarding which options will work best for you and your small business.

Business Line of Credit (LOC)

A business line of credit (LOC) is a type of financing option that business owners can use on an as-needed basis. It works a lot like a credit card in the sense that it has a credit 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 fund, etc.). When you apply for a business 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. You can use that money for whatever you want with no restrictions as long as it’s business-related.

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.

Pros and Cons

A business line of credit comes with its share of pros and cons. Let’s look at both sides of the coin:

Pros

    • Spending flexibility. With a business line of credit, you have the freedom to choose where you spend the additional capital. Whether it’s 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 the interest on the amount you’ve drawn. For example, if you have a credit line of $10,000 and you 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 the process of building their business credit.

Cons

    • Charges may add up. Lenders may charge several fees in your account throughout the lifespan of your line of credit. Some of the costs you can expect are maintenance fees, draw fees, prepayment fees, early termination fees, and late payment fees, among others. As you shop for a lender, be sure to ask candidates how much they charge for these.
    • High possibility of overuse. With easy access to cash, it can be tempting to use your credit line 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 limits. 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 business 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:

    • Inventory top-ups
    • Equipment repairs/purchases
    • Covering short-term cash shortages
    • Marketing campaigns
    • Payroll
    • Paying for seasonal expenses
    • Emergency fund

Business Line of Credit Qualifications

As with other financing options, the better your financial and credit profile is, the higher your chances are 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

If your business doesn’t meet some of the qualifications mentioned above, you may still be able to apply for a 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 with annual revenue of less than $100,000 and poor credit history. However, lenders may charge you with higher interest rates and fees to mitigate the risk.

Term Loans

Term loans are a straightforward business financing resource where business owners receive a lump sum upfront. They then pay the loan back in fixed installments (plus interest) over a predetermined period or term. Lenders usually base the loan amount, repayment period, and interest rate on the business’s financial and credit records.

Term loans usually come in three forms: Short-term, medium-term, and long-term loans. Each term loan classification is based on the repayment period, or term, of the financing. 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

There are a few benefits and drawbacks to term loans. Here are some of them:

Pros

    • 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 period. With the exception of short-term loans, the repayment period (for medium- and long-term loans) can range from two to 25 years. With the longer repayment periods, lenders can offer lower repayment amounts to the borrowers. This makes it less of a burden to businesses as they won’t have to take out a significant amount each month to put towards loan repayments.
    • Lower interest rate. Again, with the exception of 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’re applying from traditional lenders.

Cons

    • 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 small businesses. So, if your business doesn’t have a strong cash flow or a strong credit history, 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 record. Ideally, businesses should show a strong flow of revenue and a good credit score (680 or higher). For newer companies who haven’t been operating long enough to build up a substantial credit history, these requirements will be more challenging to meet.
    • Collateral is almost always required. Extending credit to small businesses is considered a risky endeavor. That said, lenders may require collateral (equipment, real estate, inventory, etc.) as security if the company becomes unable to 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:
      • Equipment repairs
      • Equipment purchases
      • Payroll
      • Store or office remodeling
      • Inventory
      • Temporary cash flow shortages
    • The primary uses for medium-term loans include:
      • Product expansion
      • Business space renovations
      • Business partnerships
      • Refinancing debts
    • 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 will require firms to present strong financials and strong credit history. To qualify for a term loan, the company should have:

    • 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 at qualifying for term loans.

Comparing Lines of Credits and Term Loans

Business lines of credit and term loans 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.

One way that small businesses can take advantage of term loans is to consolidate debt. Many small businesses accumulate debt from credit cards or other financing options, which can quickly become foreboding. A term loan can be used to consolidate debt from other loan sources, allowing you to make a single monthly payment. You can also use term loans if you’re looking to invest in larger projects such as setting up additional warehouses, opening another branch, acquiring businesses, and more.

Business lines of credit are great for recurring, short-term spending. Examples of costs that lines of credit are perfect for include payroll and unexpected or temporary expenses. You can also take advantage of a line of credit if you can’t qualify for traditional loans because of a poor credit rating. When you need quick money to keep your small business at a competitive advantage, this type of financing plan is the best option.

Lines of credit and term loans are just two of the many financing options available for small business owners. When making funding decisions, it’s essential to consider the different opportunities and understand the costs and benefits associated with each.

Ezra Cabrera
Ezra Neiel Cabrera has a bachelor’s degree in Business Administration with a major in Entrepreneurial Marketing. Over the last 3 years, she has been writing business-centric articles to help small business owners grow and expand. Ezra mainly writes for SMB Compass, but you can find some of her work in All Business, Small Biz Daily, LaunchHouse, Marketing2Business, and Clutch, among others. When she’s not writing, you’ll find her in bed eating cookies and binge-watching Netflix.

Related Articles

How Much Does Instacart Pay?

How Much Does Instacart Pay?

Key Takeaways What is Instacart? How Does Instacart Work? How Much Does Instacart Pay? Pros and Cons of Driving and...