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Term Loan vs. Line of Credit: Comparing Business Financing Options

BusinessTerm Loan vs. Line of Credit: Comparing Business Financing...

When you need financing for your small business, many business owners choose between two popular options: a business term loan or a line of credit. With a term loan, you borrow a lump sum of money up-front and agree to a fixed repayment schedule. On the other hand, you can tap into your line of credit as needed, up to a predetermined limit. As you repay your line of credit for business, you restore your limit. 

Both options could help you cover business expenses, but each has unique drawbacks and advantages that make it better suited for specific situations. Comparing the two options and understanding their differences could help you find the best fit for your business needs.  

Term Loan vs. Line of Credit: Main Differences

While both a term loan and a line of credit improve cash flow for small businesses, the two options vary in more ways than just how you access capital. Three main differences to understand between a business term loan and a line of credit are the application requirements, repayment terms, and the way interest is charged.

Requirements 

Each lender has unique eligibility requirements for loans and lines of credit, but term loans tend to have stricter requirements. Applicants for both products must usually meet certain minimum business credit score thresholds. However, term loans may also require some form of collateral, while lines of credit are typically unsecured. When you put up collateral, you must also go through an appraisal process which can be lengthy, making it an unideal option for businesses that need cash soon.

While you can use either option for many types of business costs, term loan applications usually require you to disclose your plan for the funds as part of your application. That means term loans may be a better fit for specific projects with fixed costs than they are for more general business needs. 

Repayment terms

Repayment terms for term loans are typically consistent and structured. When you accept a term loan, you agree to repay the borrowed amount in fixed installments over a predetermined period. Payments are usually based on both the principal amount and interest. 

The duration of the repayment period can vary widely depending on the loan amount and lender, but it won’t change over time so long as the loan is fixed-rate. This consistent repayment schedule provides clarity and predictability, which can help financial planning and budgeting within your business.

With a line of credit, you can borrow up to a certain amount as needed and repay only the amount you use, like a credit card. This means your monthly payments may vary based on how much of your available credit you’ve expended. 

You can continue to borrow as you repay your balance, which can be particularly useful for managing cash flow fluctuations and unexpected expenses. This flexibility, however, requires disciplined financial management to ensure the credit line doesn’t lead to overextension of your business finances.

Interest 

Because term loans are paid out as a lump sum, the entire balance accrues interest—regardless of how much you spend. That means if you borrow $250,000 but only spend $200,000, your interest charges are based on the full $250,000. Term loans, however, may have lower APRs than lines of credit. 

With a line of credit, you only owe interest on the amount you spend, not your entire credit limit. If you receive a $50,000 line of credit, but you only spend $30,000 at a time, only your $30,000 balance accrues interest, functioning in a similar manner to a credit card. Your line of credit may have a variable interest rate, which changes with shifting market conditions. To avoid unexpected bills, pay close attention to your APR, which should appear in your statement. 

To choose the right financing option for your business, consider your specific needs. If you need a loan for a fixed expense, like a piece of equipment or a capital project, a term loan may be the right fit. For a more flexible option with fewer qualifications to help your business manage cash flow, consider a business line of credit from a trusted institution or company. 

When a Term Loan Makes Sense

A term loan may make the most sense for:

  • Funding for a specific project or purchase
  • Set repayment terms and dates
  • Large loan amounts
  • Securing lower interest rates
  • Securing a loan with collateral to strengthen an application

When a Line of Credit Makes Sense

A line of credit may make the most sense for:

  • Flexible cash flow requirements
  • Unplanned business expenses
  • Small, regular business expenses
  • Less strict application requirements

Where to Get Business Term Loans or Lines of Credit

Businesses have several options for obtaining term loans and lines of credit, including traditional banks, credit unions, and online lenders. Traditional banks typically offer competitive rates and terms but may require a strong credit history and collateral for term loans. Local credit unions offer personalized service, competitive rates, and flexible terms tailored to small businesses in the community. Online lenders provide quick access to financing with streamlined processes, catering to businesses with diverse credit profiles. 

Before choosing a lender, check to see what industries they have experience working with and what products they offer. Comparing lenders could help you find the ideal match for your business.

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