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Business Loan or Line of Credit? The Best Option for Your Small Business

Business.com / Funding / Last Modified: February 22, 2017

The trickiest part of launching any business is the financial state, but what type of loan is really right for you?

Most businesses have inconsistent income streams, with some months busier than others.

Often in the early years, this means a business has a difficult time paying bills and coming up with the money they need to develop prototypes or invest in marketing materials.

A business loan is a great option for businesses that need to get themselves to a certain point before they can start making money.

But what is the best type of business loan for your small business?

With so many options available, it’s important to know what the differences are before meeting with a loan officer.

Some businesses may need a loan, while others will find a line of credit is a better course of action. Here are a few things to know to help you make a decision.

Related Article: Applying for an SBA Loan vs. Funding From an Alternative Online Lender

Loan vs. Line of Credit: Term of Loan

With a business loan, a business is issued a fixed amount, which it can borrow against as needed. Once the funds are depleted, the business must either apply for a new amount or choose to continue without a loan in place.

Either way, the money must be paid back on a schedule determined by the lender. When a business gets a loan, often it is for a specific purpose.

A line of credit, on the other hand, is an amount granted to a business to be used as needed. If a business is given a $100,000 line of credit, that business can use none of it, use only a few hundred dollars, or use tens of thousands of dollars of it.

Monthly payments only kick in once the line of credit has been used.

Loan vs. Line of Credit: Determining Amount

The amount of a line of credit is based on a business’s projection of how much money it will need in the following year.

The amount can change from one year to the next, but generally once a line of credit is locked in, it is set for the next 12 months.

With a business loan, on the other hand, the amount of the loan will determine the amount that needs to be paid on a monthly basis.

Just as a personal loan, a mortgage, or car payment, is broken into monthly payments over a number of years, so is a business loan.

Loan calculators are available that will help business owners decide how much of a loan they can afford without depleting their monthly budgets.

Loan vs. Line of Credit: Interest Rates

One factor in monthly payments is a business’s interest rates. This can vary from one lender to the next, so it’s important to use one of the online rate comparison tools available to find the best rate.

To further reduce interest, choose the shortest repayment term possible and if a business finds it’s making more money than anticipated, the money can go toward paying the loan off early.

One way to reduce the interest rate on a line of credit is by allowing a lien to be placed on one of a business’s assets.

This is known as a secured loan. Since many small businesses don’t yet have major assets, they’ll need an unsecured line of credit, which may come with opening fees and annual fees after the first year, depending on the lender.

Related Article: Will Work for Funding: 7 Ways to Finance Your First Small Business

Loan vs. Line of Credit: Permanence

One downfall of a business line of credit is that it is subject to annual review. A bank can revoke or reduce the amount at any time and, in fact, a survey by the Small Business Association revealed that 29 percent of small business owners reported having their lines of credit reduced, with one in 10 having its line of credit called in by the bank.

Unfortunately, that reduction rate is even higher for small business loans. Between 2009 and 2012, 42 percent of respondents reportedly said they had their loans threatened in some way, which included having the limit reduced or being called in early by the bank.

This threat could impact a small business loan more, since the business would then be responsible for paying the balance due.

Businesses in need of funds have choices when it comes to the loans they choose.

By shopping multiple lenders and comparing benefits and costs, professionals can find the best financing option to grow their small businesses without substantial debt.

Related Article: Why Collateral Matters When Getting a Small Business Loan

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