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Which Financing Option is Best for Your Small Business: A Line of Credit or a Term Loan?

ByShiv Nanda,
business.com writer
|
Mar 29, 2018
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> Finance
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Know which type of loan is best for your small business situation.

If you need financing for your business, there are several options to choose from. Among your options is a line of credit and a term loan. This article briefly explains both types of financing, the key features of each option and when you want a line of credit or a term loan. Let's get started.

Line of credit 

Also abbreviated as LOC, a line of credit is an arrangement between a bank or financial institution and an individual that establishes a maximum amount of money that 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 provided that you meet all the requirements set by the financial institution, like making timely minimum payments.

Key features of a line of credit  

With a line of credit, you get

1. Flexible borrowing: An LOC offers the flexibility to borrow the amount of money you need at any time, regardless of how much or how little it is, provided, of course, it's within your credit limit.

2. No fixed terms: An LOC does not require you to make monthly payments on your outstanding balance; instead, you can make minimum payments each month, make bigger payments, or pay off your full balance, if you choose.

3. Variable interest rates: This feature can be tricky. If interest rates go down, it's cheaper to borrow money (within the limits of your line of credit). However, if the interest rates go up, it costs you more money to borrow and repay your outstanding balance.

When can you use a line of credit?

Let us look at two scenarios where using a LOC may be ideal:

  • Your small business has just completed a number of projects, and your next batch of receivables are due in a week. However, you need to pay 10 of your employees in the next four days but don't have any cash. In such a scenario, you can use the LOC to cover payroll, then pay it back as soon as your receivables come in.

  • You sell numerous products from a kiosk, and one of them is selling faster than you anticipated. You urgently need to order more and your supplier is willing to offer a great deal on the product but requires COD. You can use a LOC to pay for the product, then repay it.

 

Editor's note: Looking for a business loan? We can help you choose a provider that's right for you. Use the questionnaire below to have our sister site, BuyerZone, provide you with information from a variety of vendors for free:

 

Term loan

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-loan programs to small businesses so they have the cash they need to operate from month to month. If you have a small business, you can use the cash from a term loan to purchase fixed assets, such as equipment for the production processes.

Key features of a term loan

With a term loan you get

1. Fixed terms: Term loans often have fixed interest rates and a set time period to repay the loan. With this type of financing, you have a clearer picture of how much interest you will pay over the life of the loan and your payments are fixed. 

2. Secured and unsecured term loans: Your bank or credit union may require you to put up collateral as a way of securing the loan if you fail to repay the loan. Collateral may be your house or car. When you opt for a secured term loan, you typically pay a lower interest rate as compared to an unsecured term loan, but if there's a chance that you're not able to repay the loan, your personal assets can be at risk.

When can you use a term loan?

Let us look at some scenarios where a term loan can be used by your small business:

  • You need to buy new computers for you and your office staff of 40. Computers have an average lifespan of three years, so you could opt for a three-year term loan.

  • You own a restaurant and are looking to expand. Luckily, a larger space just became available. Moreover, you need new equipment in order to scale up. This shift in positioning and expansion will take you quite some time to pay for everything. Usually, kitchen equipment can be used up to 10 years, which allows you to stretch out the repayment term to a decade.

For big one-time purchases, such as new equipment, significant capital-intensive investments or new facilities, then a term loan might be more useful. On the other hand, a line of credit, which can be compared to using a credit card, is smaller and more flexible. It is intended for everyday expenses in order to keep your business afloat. 

Depending on whether you need to spend big or small, choose the credit option that best suits your needs. And before you sign the agreement, make absolutely sure that you understand the details of each option clearly.

Shiv Nanda
Shiv Nanda
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Shiv Nanda is a financial analyst who currently lives in Bangalore and works with MoneyTap, India's first app-based credit-line. Shiv eats, breathes and sleeps finance, to the dismay of friends who’ve endured unsolicited advice on their investment choices, budgeting skills, or lack thereof. Luckily for them, Shiv has diverted this energy toward writing about various financial topics online. He loves it when people actually ask him for advice, so email him your questions at shiv@moneytap.com. He’ll try not to get carried away with the answers!
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