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If you need financing for your business, you have several options. A line of credit and a term loan are two popular types of business loans. To decide which is right for your business, you need a clear understanding of each option, how they work and why they differ.
“A term loan provides funds upfront and comes with a set repayment plan,” said Randall Yates, president of The Lenders Network. “A line of credit works similar to a credit card, where you are given a line of credit you can borrow from as needed.”
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A line of credit (also known as an LOC) is an arrangement between a bank or financial institution and an individual that establishes a maximum amount of money the borrower can access or maintain.
You can access funds from your line of credit at any time, as long as you don’t exceed the maximum amount specified in the loan agreement and you meet all the requirements set by the financial institution, like making timely minimum payments.
With a line of credit, the interest rate tends to be variable, which means it changes with the prevailing rates in the market. When interest rates are low, you pay less. When they go up, so does your payment.
Let’s look at two scenarios where using a line of credit may be ideal:
A business line of credit can be used by any small business owner who wants access to money they can draw down when needed. It makes the most sense for business owners in a good financial position. The better your credit score, the lower the interest rate you’ll get on your line of credit. In our review of Fundbox, a top business lender, we found that its lines of credit require businesses to have a credit score of at least 600 and $100,000 in annual sales. Businesses also must have been in operation for at least six months.
In our research of the best business loans, we found many alternative lenders will extend lines of credit to business borrowers. They all have different requirements for credit scores, years in business and annual sales.
A term loan is a bank loan for a specific amount that has a specified repayment schedule and a fixed or floating interest rate. Numerous banks offer term loans to small businesses so that they have the cash they need to operate from month to month. If you have a small business, you can use the money from a term loan to purchase fixed assets, such as equipment for production processes.
Banks aren’t the only ones offering term loans. A variety of alternative lenders provide short- and long-term financing to businesses.
Here are some scenarios where a small business might want a term loan:
Term loans are a common form of business funding and are popular with businesses of all sizes. You need to have an established business and some sales to get approved. The best term loan lenders offer flexible terms and fast funding. Learn more about a top option in our full review of SBG Funding.
Justin Nabity, founder and partner of financial planning firm Physicians Thrive, gave two good reasons for choosing a line of credit:
Imani Francies, a financial expert with US Insurance Agents, provided some information on the key differences between a small business loan and a line of credit.
| Small business loan | Line of credit |
---|---|---|
Loan amount | It has higher loan amounts. It comes as a lump sum of money. | The credit limit is based on qualifying factors. You can use as much or as little of it as you need. |
Interest rates | Exact rates depend on the terms of the loan. Shorter-term loans have higher interest rates. | You pay interest only on the remaining balance you owe. Rates can be high, but not always. If you pay your balance every month, you will not accrue interest. |
Repayment | You pay it in set amounts over a fixed period. Short-term loans can have repayment terms as short as 12 weeks. You must pay back the entire loan. | There are ongoing monthly payments as long as you owe a balance. You pay back only what you use. |
Fees | Some short-term loans have prepayment fees or penalties. It can have origination fees. | There are late-payment fees. You’ll pay balance transfer fees if you use a credit card. |
Loan terms | The terms can be as little as three months or longer than five years, depending on the lender and type of loan. | Terms are longer, since borrowing and repayment are ongoing. |
Choose a term loan:
Choose a line of credit:
Depending on whether you need to spend big or small, choose the credit option that best suits your needs. However, before agreeing to any loan, closely review the loan agreement and make sure you clearly understand the details.
Jennifer Dublino and Shiv Nanda contributed to this article. Source interviews were conducted for a previous version of this article.