Line of Credit vs. Loan

September 28, 2016

Lines of credit (LOCs) and small business term loans are both powerful tools for managing finances and growth, but they are very differently structured and serve distinct needs. The best option for you likely depends on how you plan to spend the money and when you need it: You may have big plans for growth that require a significant investment, or you may require occasional access to funds to meet ongoing business demands.

The following overview of LOCs and business term loans may help you determine what sort of funding is your best choice.

How they work

A business line of credit is an amount of money that you can access when cash demands arise — you draw out the funds when a need emerges and then repay the lender with interest. For example, if you have a $5,000 line of credit and withdraw $1,000, your credit limit will drop to $4,000. Once you repay that $1,000, the amount of credit available returns to $5,000.

A business term loan, on the other hand, gives you a lump sum, typically at a fixed interest rate, with regular repayments on a set schedule. This structure means you’ll always know exactly how much the payment will be and when it’s due. Loans are usually multi-year and require monthly payments. 

Loans and lines of credit in action

Examples of how business term loans and lines of credit work in real life can help to paint a picture of how businesses rely on these tools. Use the following examples to help with your decision.

Line of credit business cases

Lines of credit work best when you have periodic, short-term needs for an infusion of cash.

Business case #1:

    • An athletics supply store wins an important contract to provide a local college with uniforms and gear. The college has a 60-day waiting period before they pay their vendors, so the business taps a line of credit to buy the supplies and pays it down once the client pays.

Business case #2:

    • A bakery’s new gingerbread cheesecake is a hit this holiday season. To fill all the orders piling up, the business needs to buy more supplies and keep staff working overtime. The holiday windfall will supply the cash the business needs to pay down the debt.

Business case #3:

  • A restaurant has advertised that it is throwing a “Pizza Party Grand Opening” to celebrate the installation of a new brick pizza oven, but city inspectors say the business needs to install an expensive air filtration system before it can fire up the oven. The business can access funds through a LOC to pay for the installation.

Business term loan business cases

The up-front sum of a term loan is useful when you want to make specific investments aimed at growing your business. Here are some cases to consider, using the same example businesses as above.

Business case #1:

    • A new form of screen printer will allow the athletics gear company to offer personalized clothing that it could charge more for. This new offering would help the business edge out competitors and provide a new revenue stream for several years.

Business case #2:

    • The bakery signed a two-year contract to sell its goods in several local supermarkets, but it will need a new truck to make the deliveries. The contract guarantees the bakery will be able to pay off the total cost of the truck plus interest, and this opportunity will expand its business.

Business case #3:

  • The space next door to the restaurant is becoming available, and expanding into it could increase the number of tables it can seat. A loan will help the business lease the space, buy more furniture and add additional staff.

What you need to know

When you draw on your line of credit, you will be charged interest on the amount you withdraw from the time you access the funds until the time you pay it back. Lines of credit typically have variable rates that fluctuate with the prime rate. That’s why LOCs may be most useful as a flexible tool for managing shorter-term cash needs.

With a term loan, you are committed to regular payments at a fixed interest rate. This predictability is helpful for business planning, but you are typically committing to regular payments for several years when you get a loan, so be sure the payment period makes sense for how you plan to use the money. For example, you typically wouldn’t want to take out a five-year loan to buy equipment that may only last for three years. It’s important to compare the full cost of the loan with the financial gain you expect from the investment.

While both financing instruments may have a place in your business toolbox, you’ll also want to ask prospective lenders about the specific terms available to you, including the total cost of the borrowing option you choose and how soon you can access the funds. Find out who will be your point of contact if you have questions or problems.

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