Table of Contents
- Understanding a business line of credit
- Understanding business loans
- The differences between a business line of credit and a loan
- Business line of credit vs business loan: How to choose what’s right for your business
- Pros and cons of business lines of credit and business loans
- Where to get business lines of credit and loans
- FAQs about business lines of credit and business loans
A lack of funding can block ambitious growth for small businesses. Whether it’s for new equipment or a financial safety net, securing financing is often crucial. However, navigating debt financing options can be complex.
This blog post explores the differences between business lines of credit and business loans—two popular choices with distinct purposes. Understanding the advantages and disadvantages of each will help you make an informed decision, ensuring you invest wisely in your company’s growth.
Understanding a business line of credit
A business line of credit (LOC) is a flexible financing option for businesses that functions similar to a credit card. It allows a company to draw funds up to a certain limit at any time, and interest is typically only paid on the amount borrowed.
How does it work?
Once an LOC is approved, a business owner can access the funds up to the agreed limit. The draw period refers to when the business can utilize these funds. During this period, the company can withdraw money, pay it back, and then borrow again if it does not exceed its credit limit. The repayment begins after the money is drawn, and the borrowed amount plus interest must be repaid.
Key features of a business line of credit
Key features of a business line of credit include:
- Flexibility in use
- The revolving nature of the funds
- Potential for lower interest rates compared to other forms of credit
Additionally, the qualification process for an LOC may be less stringent than that of a loan. Furthermore, businesses are only charged interest on the portion of the credit actually utilized, not the entire credit limit, making it a cost-effective option for managing short-term financial needs.
Common uses for business lines of credit
Business LOCs are typically used to support day-to-day operational costs, manage cash flow fluctuations, purchase inventory, or fund emergency expenses. They’re ideal for businesses with cyclical or seasonal sales patterns, allowing the flexibility to cover revenue dips.
Additionally, an LOC can be used to take advantage of business opportunities quickly, such as a limited-time discount on bulk inventory purchases.
Considering financing options for your business?Check out our small business loan calculator tool to understand your approved financing amount and weekly payment based on your business criteria. |
Understanding business loans
A business loan is a sum of money lent to a company, which must be repaid over a period of time with interest. Loans come in various forms, including short-term, medium-term, and long-term loans, each with its own repayment schedules and interest rates.
Unlike lines of credit, loans provide the borrower with a one-time, lump-sum payment which is not available for repeat use upon repayment of the used funds.
How does it work?
Upon approval of a business loan, the lender provides the borrower with the agreed-upon amount of capital. The business then uses this amount for its intended business purpose, after which the repayment process begins. Repayment usually occurs in regular installments, including the principal amount and interest.
Key features of a business loan
Key features of business loans include the following:
- Fixed repayment schedule: Borrowers agree to pay a set amount at regular intervals, which helps in financial planning and budgeting.
- Variation of loan types: There are multiple business loans to choose from, such as term loans, SBA loans, and equipment loans, each tailored to different business needs.
- Collateral requirements: Some business loans require collateral—assets such as real estate or equipment—that the lender can claim if the borrower defaults.
- Impact on credit: Responsibly managing a business loan may help build a business’s credit rating, which may facilitate easier access to future financing.
- Fixed or variable interest rates: Rates can be locked in (fixed) or change over time (variable), affecting the total cost of the loan.
Common uses for business loans
Business loans are leveraged for a range of uses, including but not limited to:
- Starting a new business or purchasing an existing one
- Expanding operations or entering new markets
- Financing large purchases, such as property or heavy machinery
- Renovating or improving existing business facilities
- Refinancing or consolidating existing business debts
Learn more about your business financing options: |
The differences between a business line of credit vs. a loan
So, what are the differences between a business line of credit vs. a loan?
A business LOC offers a flexible fund reservoir you can draw from as needed, up to a predetermined limit, and interest is charged only on the money used.
A business loan provides a fixed amount of capital upfront, which you will pay back, with interest, over a fixed period.
Let’s explore how these options differ in structure, repayment, costs, flexibility, and collateral requirements.
Structure and access to funds
- Business LOC: Works a lot like a credit card. You’re granted access to a certain amount of funds, which you can draw on as needed. You have the option to not use the entire credit line, and you can use the funds multiple times as long as you don’t exceed your limit.
- Business loans: When approved, they give you a lump-sum amount. Once the initial amount is disbursed, you cannot borrow more funds from the loan.
Repayment terms
- Business LOC: Repayment terms usually offer more flexibility. You only make payments based on the amount you’ve borrowed. Additionally, you may be allowed to pay off the balance in full at any time without prepayment penalties.
- Business loan: You’ll have a fixed repayment schedule, typically with regular monthly payments. Some loans might have penalties for early repayment, so make sure you understand the terms upfront.
Interest rates and costs
- Business LOC: Interest rates for business LOCs can be higher than loans and are often variable, meaning the rate could rise or fall over the life of the line of credit. However, because you’re only paying interest on the funds you actually use, the overall cost could be lower if your utilization is minimal.
- Business loan: It usually comes with fixed or variable interest rates, but the total interest cost is predictable when a fixed-rate option is chosen, which aids in long-term financial planning.
Flexibility in usage
- Business LOC: Provides a high level of flexibility and can be used for virtually any business purpose, including emergency expenses or to smooth out cash flow fluctuations.
- Business loan: A business loan sometimes has restrictions, ensuring the funds are utilized for the intended purpose described during the loan application process.
Collateral requirements
Business LOC: Secured lines of credit require collateral, but unsecured lines of credit can also be obtained, often at a higher cost.
Business loan: Compared to an LOC, collateral is more commonly associated with business loans, especially for larger amounts or loans from traditional banks.
Business line of credit vs. loan: How to choose what’s right for your business
The decision between getting a business line of credit and a business loan should hinge on a comprehensive needs assessment, factors in your operating cash flow requirements, the nature of your funding necessities—long-term or short-term—and your company’s risk tolerance level.
Let’s see how everything compares in the table below:
| Choosing Between a Business Line of Credit vs. a Business Loan | ||
|---|---|---|
| Line of Credit | Loan | |
| Financial needs assessment – evaluate your company’s financial needs | Best suited for businesses with ongoing or cyclical financing needs and may not be able to predict the amount of funds required at any given time. | Ideal when the amount of funding needed is known, and the purpose is a specific, one-time investment, such as an asset purchase or a major expansion project. |
| Cash flow considerations – ensure health cash flow for business sustainability | Allows customers to withdraw funds up to a certain limit, incurring only interest on the drawn amount. It ensures flexibility in managing the ebb and flow of cash requirements. | Provides certainty in cash outflows with fixed monthly payments, allowing for more predictable budgeting. However, during lean periods, these fixed obligations could strain cash reserves. |
| Long-term vs. short-term needs – how long do you need funding? | May be more effective for immediate or transitional financing due to its reusable nature after repayment. | May be more fitting for strategic investments that bear fruit over a longer period due to typically larger sums available and potentially lower interest rates. |
| Risk tolerance – how much risk can your business handle? | Generally entails a variable interest rate that can fluctuate, so assessing whether the business cash flows can sustain these potential variations is essential. | If providing collateral is a concern, understand that although secured loans often have better rates, you may risk losing assets if the loan defaults. |
The pros and cons of business lines of credit and business loans
Understanding the benefits and drawbacks of a small business loan vs. a line of credit can help business owners align their choices with their operational requirements and long-term business strategies. Below, we delve into both financing mechanisms’ significant positives and negatives.
Pros of a business line of credit
- Flexibility: A business line of credit allows business owners to draw funds as required, providing financial flexibility to manage cash flow or handle unexpected expenses.
- Pay for what you use: Interest is charged only on the amount of money utilized, not on the total credit available.
- Reusability: Once repaid, the funds become available again within the credit limit, offering a renewable source of capital.
- No prepayment penalties: Many lines of credit allow for early payments without additional fees, allowing businesses to save on interest if they can repay funds ahead of schedule.
Cons of a business line of credit
- Higher costs for unused funds: Maintaining an unused line of credit may incur costs, such as annual or transaction fees.
- Variable interest rates: Typically, business lines of credit have variable interest rates, which can fluctuate and unexpectedly increase the cost of borrowing.
- Stricter qualification requirements: For unsecured lines of credit, businesses might face stringent qualification criteria, including strong credit scores and a proven financial track record.
- Lower borrowing limits: Compared to business loans, lines of credit may offer lower maximum borrowing limits, limiting the amount of available funds for large-scale projects or purchases.
Pros of a business loan
- Fixed terms: Business loans come with a set repayment schedule, which can assist with budgeting and financial forecasting.
- Lower interest rates: Business loans may generally have lower interest rates than lines of credit, particularly for fixed-rate options, potentially saving on total borrowing costs.
- Large funding amounts: Loans can provide substantial lump-sum capital for significant investments, such as purchasing equipment or real estate.
- Use restrictions can be positive: The restrictions on how loan funds can be used can encourage businesses to stay focused on their intended growth plans or projects.
Cons of a business loan
- Less flexibility: Once funds are disbursed, you can’t access additional money without applying for a new loan.
- Fixed payments: Regular, fixed payments may pose a challenge during slow business periods, leading to cash flow strains.
- Early repayment penalties: Some loans have prepayment penalties, which can make it costly to pay off the loan before the end of its term.
- Collateral required: Larger business loans often require collateral, which could put business assets at risk if the loan cannot be repaid.
Want to evaluate your financing options?Check out our small business loan calculator tool to understand your approved financing amount and weekly payment based on your business criteria. |
Where to get business lines of credit and loans
Depending on a business’s financial health, the purpose of the funds, and flexibility needs, business owners need to weigh the advantages of a business line of credit vs. a business loan.
Another important factor to consider is which lender to choose from.
Banks
Banks are a traditional source of funding, offering loans and lines of credit. Community Development Financial Institutions (CDFIs) are banks that typically serve low-income communities and can be a good option for businesses that may not qualify for traditional bank lines or loans.
Credit unions
Credit unions are member-owned financial cooperatives that often offer favorable terms and rates for their members. Both products are usually available at credit unions, with the added benefit of personalized service.
Online lenders
Online lenders can typically offer more flexible lending solutions and cater to various credit profiles. For example, online lenders like Credibly can provide loan solutions, and through lending partners, provide access to lines of credit as well.
FAQs about business lines of credit vs. business loans
Why would a business use a line of credit rather than obtain a loan?
A line of credit offers more flexibility, allowing businesses to draw funds up to a certain limit as needed. This is ideal for managing cash flow and unexpected expenses without committing to a lump-sum loan.
Can a business use both a line of credit and a loan simultaneously?
Yes, businesses can leverage both financing methods simultaneously for different financial needs. A loan may fund a specific large project, while a line of credit can cover operational expenses.
Why use credit when you have the cash?
Using credit can help preserve cash reserves for unforeseen events and build a business’s credit history, which may be beneficial for future financing. Keeping cash on hand is a good business practice and can ultimately protect you in the long run.
Is getting approved for a business loan or line of credit easier?
It depends. Approval relies on multiple factors, including creditworthiness and the lender’s criteria. However, unsecured lines of credit might have more stringent requirements due to their flexibility and risk to lenders.
Ready to expand your business?Start with our small business loan calculator tool to understand your approved financing amount and weekly payment based on your business criteria. |
