Small business owners who find themselves in need of extra capital are often posed with a dilemma. Do they want to apply for a small business loan or perhaps lines of credit would better suit them?Sometimes, it depends on what the money is going to be used for and other times it’s the term length of the loan which may be in question. If you are looking for funding and are wondering which is better for your business, it may help to understand the difference between business loans and lines of credit.
What Exactly Is a Line of Credit?
Most people know that loans can be secured or unsecured, and are usually dependent upon their credit history and current score. The same holds true with business loans. Lines of credit are similar in this regard, with a few important differences. Just like a loan can be secured or unsecured by a company’s accounts receivable or inventory, so too can a line of credit be secured or unsecured. The major difference is that a loan is a set amount which you borrow with an agreed interest rate (fixed or variable) and that doesn’t change for the duration of the loan.
A line of credit, on the other hand, may experience significant changes in interest rates if you are late on payments or borrow over your line of credit limit. Another big difference is that you can tap into your lines of credit time after time, up to the limit you are approved for. Think of it like a credit card. The limit sits there until you use it and is reduced only by as much as you borrow. So, if you have a limit of $100,000, you can ‘borrow’ against that amount as many times as necessary as long as you don’t exceed it. The limit will remain the same and as you pay it down, you can borrow again up to the approved limit.
Basics of a Business Loan
Business loans, as mentioned above, are typically term loans in which the payments begin immediately upon receiving the funds. The interest rate on business loans is usually higher than that of lines of credit and your payments are based on the amount borrowed plus interest, amortized over the length of the loan. This type of loan is best suited for a long-term investment such as when building a new production facility or ordering expensive new equipment. If the amount being borrowed will take a long period to pay off, a business loan is typically the better option for your business.
However, if you are in need of operating capital while awaiting accounts receivable to be collected, a revolving line of credit may be your better option. Again, you must consider both the amount and the length of time it will take you to repay the loan before choosing between the two. Interest rates are important as well.
In the end, it depends on whether a set amount is sufficient or if you will need to tap into funds repeatedly. Once you know that, your choice is easy.