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Choosing the right type of business financing is an important decision for any business owner. Two common options are business lines of credit and term loans. These products work differently and are designed for different business needs.
Understanding the structure and features of each option makes it easier to compare them. Below, each product is explained in simple terms, starting with term loans.
What is a Term Loan
A term loan is a type of business financing where a company borrows a specific amount of money and agrees to pay it back over a set period. The repayment is made through regular, scheduled payments that include both the amount borrowed and interest.
When comparing term loan vs line of credit options, term loans provide all funds upfront in a single lump sum. This makes them ideal for large, one-time purchases like equipment or real estate.
Key features of term loans:
- Lump-sum disbursement: All the borrowed money is provided at once
- Fixed repayment schedule: Payments are made on a regular basis, usually monthly, for the entire loan term
- Predetermined loan term: The length of the loan is established upfront, commonly lasting one to ten years
- Interest structure: Term loans may have either fixed or variable interest rates
Each payment includes both principal (the original borrowed amount) and interest (the cost of borrowing). This structure provides consistency in how much is paid each month, making it easier for businesses to budget and plan their cash flow.
A fixed interest rate does not change over the life of the loan, while a variable interest rate can go up or down depending on changes in market rates. Fixed rates offer predictability, but variable rates might start lower.
Some term loans require collateral, which is an asset pledged as security for the loan. Examples include equipment, property, or inventory. Unsecured term loans don't require collateral but typically have higher interest rates to offset the increased risk to lenders.
What is a Business Line of Credit
A business line of credit provides access to a set amount of money that can be borrowed, repaid, and borrowed again. It operates similarly to a business credit card but often comes with higher credit limits and different terms.
Unlike a term loan, which provides a single lump sum, a line of credit offers ongoing access to funds as needed. This flexibility makes it particularly useful for managing cash flow or covering unexpected expenses. According to the 2024 Small Business Credit Survey, 40% of small businesses applied for a business line of credit, making it the most commonly sought form of financing. This flexibility makes it particularly useful for managing cash flow or covering unexpected expenses.
Key features of business lines of credit:
- Revolving credit limit: The credit limit is the maximum amount available to borrow
- Draw-as-needed access: Funds can be withdrawn at any time, in any amount up to the credit limit
- Interest on used funds only: Interest accrues only on the amount currently borrowed
- Repayment flexibility: Minimum monthly payments are required, but the full balance can be repaid anytime
The revolving nature means that as amounts are borrowed and repaid, funds become available to use again, up to the established limit. This differs significantly from the line of credit vs term loan structure, where term loans provide funds only once.
Interest is charged only on the amount that has been withdrawn from the line of credit. Some lenders may also charge a small fee each time funds are accessed, called a draw fee. These fees typically range from $25 to $100 per draw.
Working capital refers to the money needed for daily operations. A line of credit helps cover temporary gaps in cash flow, manage seasonal changes, or pay for unexpected costs like emergency repairs or sudden opportunities.
Business Line of Credit vs Term Loan: Key Differences
The main difference between loan versus line of credit is how money is provided and how it is paid back. Understanding these differences helps businesses choose the right financing option for their specific needs.
Funding structure differences:
A term loan gives all funds at once, commonly used for buying equipment, real estate, or other large expenses. A line of credit allows access to funds as needed, up to a set limit, and funds can be drawn, repaid, and drawn again.
Repayment approach variations:
Term loans follow a fixed repayment schedule, usually with the same amount due each month. This makes future payments predictable and easier to budget for. A line of credit has a flexible repayment structure where only a minimum payment is required each cycle, but higher payments or full repayment are allowed at any time.
Interest on a term loan is charged on the entire amount from the start, and rates are often lower for businesses with strong qualifications. A line of credit charges interest only on the amount currently borrowed. Rates and fees can be higher, but interest applies only to funds in use, not the full credit limit.
Common use cases:
- Term loans: Equipment purchases, real estate acquisitions, business expansion projects, debt consolidation
- Lines of credit: Inventory purchases, payroll gaps, seasonal cash flow management, emergency expenses
How to Choose Between a Term Loan vs Line of Credit
The decision between a business term loan vs line of credit depends on several factors including funding needs, repayment preferences, and business qualifications.
Assess your funding requirements:
Term loans work best for situations where a business requires a specific amount of money at one time, such as for a large project or purchase. Business lines of credit are designed for flexible, ongoing access to funds, which can be useful for handling expenses that come up over time.
Consider whether the need is for a lump sum or repeated access to smaller amounts. A restaurant buying new kitchen equipment would likely choose a term loan, while a seasonal retailer managing inventory fluctuations might prefer a line of credit.
Evaluate repayment preferences:
Term loans have set monthly payments, which remain the same for the duration of the loan if the interest rate is fixed. Business lines of credit offer flexible repayment, allowing a business to pay the minimum required or more at any time.
The choice depends on whether steady, predictable payments are preferred, or if flexibility is more important due to varying cash flow patterns throughout the year.
Compare costs and qualification requirements:
Term loans may offer lower rates for qualified businesses, but interest applies to the full amount borrowed from day one. Lines of credit may have higher rates or fees, but interest is only charged on what is drawn. Additionally, the small business lending market is projected to grow at a compound annual growth rate of 13% from 2024 to 2032, ultimately reaching a market size of $7.22 trillion.
Lenders often require higher credit scores, longer time in business, and more established revenue history for term loans. Business lines of credit may have less strict requirements and can be accessible to businesses with shorter histories or fluctuating revenue.
Avoiding Common Business Financing Mistakes
When considering a business loan vs line of credit, several common mistakes can impact a business's financial health and long-term success.
Focusing only on interest rates:
Interest rates represent just one factor in the total cost of borrowing. Fees, repayment schedules, and other charges can increase the overall expense, even when the interest rate appears low. A loan with a lower rate but high origination or maintenance fees may end up costing more than a loan with a slightly higher rate but fewer additional charges.
Mismatching financing type to business needs:
The intended use of funds affects which financing option is most appropriate. Term loans are designed for large, one-time investments, while lines of credit are structured for ongoing or fluctuating expenses. Using a term loan for day-to-day operating costs or a line of credit for a substantial, single purchase can result in higher costs or create cash flow challenges.
Overlooking qualification requirements:
Lenders may have requirements such as personal guarantees, financial covenants, or collateral to secure the financing. Failing to review all terms may expose a business to risks if requirements are not met. Reading and understanding all conditions before agreeing to any financing helps avoid unexpected obligations.
Finding the Right Business Financing Solution
Selecting between a business line of credit versus loan depends on the specific requirements and goals of a business. Some businesses look for funding that covers one-time, large expenses. Others prefer access to funds over time to handle ongoing or unpredictable costs.
The process involves comparing features, repayment terms, interest rates, and qualification criteria of each option. Fundwell provides a transparent platform where business owners can review and compare these choices side by side.
Through Fundwell's platform, users have access to clear terms and professional guidance for both term loans and lines of credit. This approach centers on offering options and information, allowing each business to select the financing solution that fits its unique needs.
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Frequently Asked Questions About Business Lines of Credit and Term Loans
Can a business have both a term loan and line of credit simultaneously?
Yes, many businesses maintain both a term loan and a line of credit at the same time, using each for different purposes as long as they meet lender requirements and maintain manageable debt levels.
How quickly can businesses access funds from term loans versus lines of credit?
Term loans typically take several days to a few weeks for approval and funding, while lines of credit can provide access to funds within a few days after the initial approval process is complete.
What happens if a business cannot make payments on time for either option?
Late payments on either a term loan or a line of credit can result in late fees, damage to credit scores, and potential legal action or loss of collateral if the loan is secured.
Which financing option works better for new businesses?
Lines of credit are often more accessible for new businesses since term loans typically require a longer operating history and stronger financial documentation to qualify.
Can businesses convert a line of credit balance to a term loan?
Some lenders offer the option to refinance a line of credit balance into a term loan, which allows the outstanding balance to be paid off over a set period at a fixed interest rate.
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