If you’re seeking capital to run and grow your small business, you may be debating between a line of credit and a term loan. But how do these two small business loans work, and in what situation should you apply for each one? Here’s a closer look:
Business line of credit: A business line of credit is similar to personal lines of credit, such as credit cards or home equity lines of credit. You have access to a specific amount of financing—say, $50,000—but you don’t make payments or incur any interest until you tap into the funds.
Lines of credit can be secured or unsecured business loans (typically by inventory or receivables). They are often referred to as “revolving,” which means you can tap into them again and again. For instance, if you have a $50,000 line of credit and take out $25,000, you still have access to the remaining $25,000. If you pay that $25,000 back down to $0, you still have access to the entire $50,000 without reapplying.
A line of credit typically has a lower interest rate and closing costs than a loan of comparable size. However, if you’re late with a payment or go over your borrowing limit, your interest rate may increase substantially—unlike a term loan, where the interest rate stays the same for the life of the loan.
Term loan: With a business term loan, you borrow a lump sum of money, get it all at once and pay it back over a specific time period (or “term”)—it can range from a year to 20 years. Unlike lines of credit that are typically renewed every 1 – 2 years, a term loan is fixed for the specified amortization period. Lenders prefer loans to be collateralized, but there are options for unsecured terms notes.
You can select term loans with different repayment periods and with fixed or variable interest rates. However, you must begin repaying the loan immediately (even if you don’t use the money right away). Closing costs and interest rates for term loans are typically higher than those on a business line of credit. And, unlike a revolving line of credit vs loan, once you use up all the loan funds, you’ll need to reapply for a new loan.
So, what is best for you and your business? While that is ultimately up to you, most agree that having a credit line is better than constantly owing money. So, when you are in need of funding, look fo a credit line (often called a merchant cash advance) from a reputable merchant account provider like First American Merchant.