Depending on why the financing is needed, small businesses can seek a line of credit or take out a business loan. But before you decide on one source or the other, you should have a full understanding of each and how they differ. After all, your business depends on it.
What is a Business Loan?
A business loan provides a company with a single, lump sum amount of money for a specific purpose.
The borrowed funds are usually used to purchase property, grow operations, or expand into new services or products.
How Does a Business Loan Work?
A lender provides a business with a one-time sum it expects to be repaid as contractually agreed upon.
To offset the costs and risks of lending money, the lender subsequently charges fees and interest — fixed or variable. With the latter, rates can change over the life of the loan.
Borrowers will also have an established amount of time in which the loan must be repaid, with terms typically ranging from six months to 10 years. Your terms, and the amount you’re offered, depends on the lender and the business’s eligibility.
What is a Business Line of Credit?
A business line of credit works like a credit card, in that businesses can tap revolving funds repeatedly to cover sudden expenses, fluctuating cash flow needs, or large purchases, with interest only charged on the amount used.
Access to short-term funding can support, say, inventory needs, or operational expenses like supplies or payroll. It can also be used for growth initiatives that require more funding, and to help bridge seasonal slowdowns.
How Does a Business Line of Credit Work?
Once a business begins drawing from their credit line, the repayment term begins and interest is calculated on the amount borrowed. The loan is typically repaid weekly or monthly.
When funds are drawn, the amount of credit available is reduced by the amount borrowed. But once your business makes a payment, the amount available is replenished by that total.
Note that you may have to pay a draw fee every time money is borrowed, which is in addition to interest payments.
Business Loan vs Line of Credit
You may be wondering, should I get a business loan or line of credit? Well, there are differences between the two.
With a business loan, funds are provided in a lump sum. Following loan approval, you can begin paying the funds back, with interest. Also, unlike for a line of credit, you typically must declare the loan’s purpose on the loan application.
And compared with a line of credit, you’re typically offered higher amounts with business loans and have longer repayment terms. However, a business line of credit permits you to draw funds whenever you wish, paying interest only on the amount drawn.
What’s more, you may be able to get a line of credit with a less-than-stellar credit history. By contrast, most business loans require a strong credit rating.
When to Consider a Business Loan
Keeping in mind the differences between business loan and line of credit, the former may be best for your business if you:
- Require a loan for a certain purchase
- Want established repayment terms with a set end date
- Need a higher loan amount
- Do not need to use the credit for future purchases
When to Consider a Business Line of Credit
You may want to consider a business credit line if you:
- Require access to credit as needed
- Want to use the line for future purchases
- Want to just pay interest on the amount withdrawn
- Need to cover cash flow gaps
- Are not eligible for a traditional bank loan
In Summary
While there may be overlap in how funds can be used from with a business loan or line of credit, the amount you need, ability to reuse credit, and the interest rate can help you select the best choice for you.
