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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 boost it needs.
The starting point to finding the right financing for your small business is to choose the type of financing that will best suit 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
First, what are term loans 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, which means they require some form of collateral — often equipment, real estate or a lien on your assets. You can typically fund unsecured business loans in amounts up to $50,000, while you can find secured loans up to $1.25 million or sometimes higher.
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 actually use. You typically have to repay at least the minimum amount over a specified number of years, which means you don’t have to make consistent or scheduled repayments.
What are the 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. Depending on the lender, you could possibly pay your loan back with monthly instalments, weekly or bi-weekly instalments or daily payments.
Lines of credit
- Only pay interest on what you use. Rather than having to repay a lump sum, you have the freedom to spend only what you need and pay interest on the borrowed amount.
- Only pay the minimum. Most lenders require that you only pay the minimum each month – which can be a helpful feature if you’re short on cash one month.
- 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 at any time. You’re able to withdraw up to a daily or set 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.
- Fees. Many lenders charge a one-time origination fee that can cost anywhere from 1-7% of your total loan amount, plus other possible fees like prepayment.
Lines of credit
- Not great for large purchases. While it’s possible to max out your credit limit, you won’t have any other funds available to cover expenses until you’ve paid back some of the borrowed funds.
- 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 or you only pay the minimum some months, it can be difficult to calculate a budget for loan repayments.
- Fees. Some lenders charge a fee to maintain your account or charge you a fee every time you want to draw funds from your credit line.
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
Compare business loans
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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