If you need financing for your business, you have several options. A line of credit and a term loan are two popular options. To decide which is right for your business, you need a clear understanding of each option, how they work and how they differ.
“A term loan provides funds upfront and comes with a set repayment plan,” said Randall Yates, CEO 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 home equity line of credit, or HELOC, is a line of credit given to a borrower using the equity they have in their home as collateral, Yates explained. A HELOC allows you to borrow up to 80% of the market value of your home.
“It acts like a credit card where a limit is established that you can borrow from on a regular basis,” added Tyler Forte, CEO of real estate brokerage Felix Homes. “Since the property is collateral, the credit limit is higher than credit cards and the interest is generally lower.”
The good thing about a HELOC is that there is usually no commitment fee, according to Rob Stephens, CPA and founder of CFO Perspective.
“They have a draw period of five to 10 years, during which they are revolving lines of credit,” Stephens said. “One way they’re better than a business line is that there are no resting requirements.”
Typically, startups or businesses in the early stages that need capital will use a home equity line of credit to fund their operations. Once they are more established, they usually turn to different funding options for capital.
According to Stephens, credit cards are usually unsecured, and you can’t borrow as much as you can with a revolving line of credit. He said they are made for small purchases.
Yates added that credit cards have higher interest rates than revolving lines of credit.
“Revolving lines of credit may be unsecured or secured by inventory or accounts receivable,” he said. “You can usually get a much bigger line of credit than you can get with a credit card.”
Business credit cards are one of the most common forms of revolving lines of credit for businesses, according to Forte.
Justin Nabity, founder and CEO of financial planning firm Physicians Thrive, gave two good reasons for choosing a line of credit:
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.
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.
Imani Francies, financial expert with US Insurance Agents, provided some information on the key differences between small business loans and lines 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.|
For big one-time purchases – such as new equipment, significant capital-intensive investments or new facilities – a term loan might be more useful. On the other hand, a line of credit, which is comparable to a credit card, is more flexible and intended for everyday expenses to keep your business afloat.
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.
Shiv Nanda and Jennifer Post contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.