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Business term loan vs. line of credit: Which is right for your business?
Choose the best type of financing to give your business the financial boost it needs.
The most important thing to consider when finding financing for your small business is choosing the type that will best suits your business’s needs. Here, we take a look at the two main options: a term loan and a line of credit.
Top three advantages of business term loans and lines of credit
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First, what are term loans and and lines of credit?
Term loans and lines of credit are both types of financing that you can use to help your business cover expenses and grow.
Term loans come in lump sums that you repay over a fixed period of time plus interest and fees. Once you spend all the available funds, you’ll need to apply for a new loan if you need more financing.
Many business loans are secured, in that they require some form of collateral — often equipment, real estate or a lien on your assets. Even those that don't require a business asset as collateral do require a personal guarantee. And applying as a startup without any assets can make approval difficult.
Line of credit
Business lines of credit are often compared to credit cards: You get access to a certain amount of funds which you can draw from as you need. With a business line of credit, you only pay interest on money that you use.
You’ll typically have to repay the amount you draw over a set period of time, after which you can renew your credit line. Just like with term loans, it can be difficult to get a line of credit as a startup — but not impossible.
What are benefits of term loans vs. lines of credit?
- Fixed or variable rate of interest. Many lenders will let you choose between a loan with a set interest rate and one that fluctuates with the market rate. Variable rates tend to start lower but could increase over the term of the loan.
- Flexible repayment plans. Some loans offer multiple repayment options to choose exactly how much you pay back and when. You could pay your loan back with monthly installments, weekly installments or daily payments.
- Discounted rates. In return for paying interest on a sizable loan, lenders regularly offer discounts for things like setting up automatic payments.
Lines of credit
- Only pay interest what you draw. Rather than having to repay a lump sum, you have the freedom to spend only what you need and pay interest on that amount.
- Option to renew. While lines of credit come with terms, they’re easily renewable. Many businesses have lines of credit with a lender for years, which they continually renew.
- Make withdrawals any time. You’re able to withdraw up to a daily or card limit at any time, making it a convenient option for business owners who have ongoing expenses or want to be prepared for large unexpected expenses.
What are the drawbacks?
- Can’t help with cash flow. Term loans aren’t great for covering unexpected gaps in your cash flow, since you’ll typically have to calculate exactly how much you need to borrow when you apply.
- Inflexible. With a term loan, repayments start immediately and you’re on the hook for the amount you borrow, even if you don’t end up using all of it.
- It takes effort to get more financing. If you still need funds, you’ll have to go through the application process all over again, rather than just renewing your loan.
Lines of credit
- Not great for large purchases. While it’s possible to max out your credit limit on a new piece of equipment, you won’t have any other funds available to cover expenses until you’ve paid it off.
- Unpredictable repayments. Your monthly repayments go up each time you draw from your credit line. If you don’t know how much you’re going to be drawing, it can be difficult to calculate a budget for loan repayments.
- Draw fees. Some lenders charge you a fee every time you want to draw funds from your credit line— usually around $25.
What types of costs can I cover with term loans and lines of credit?
Term loans are often best for large, one-time purchases or specific purposes. You might want to use a term loan for:
- Real estate
- Business acquisition
Line of credit
Lines of credit are usually better for covering smaller, short-term expenses that are difficult to predict. These include:
- Overhead costs during an off season
- Restocking inventory
- Emergency expenses
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How to get business financing
The processes involved in finding approval for a term loan are simple. The lender will want historical evidence of successful cash flow and assurance of collateral, should your company be unable to repay the loan.
The prerequisites for a line of credit are similar but more stringent. Along with a contract of repayment terms, lenders will provide a list of rules that must be kept in order to continue with the line of credit. These rules will usually involve the company maintaining a certain net worth and not dropping below an agreed level of debt.
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