When your small business needs some cash injection, you typically have two options: a line of credit or a loan. A line of credit presents you with an ongoing pool of cash to dip into whenever your business is strapped for funds. On the other hand, a small business loan offers a one-time lump sum amount.
But which of these two financing options is best for your business? Below is a more detailed look at small business line of credit vs. business loan for small businesses:
What Is a Business Loan?
A business loan is a credit facility that provides business owners with a one-time, lump sum amount of cash. You then have to pay it back over time – which explains why business loans are also called term loans. Repayment involves paying the principal amount as well as interest.
Small business loans can either be long-term or short-term. A long-term loan is designed to fund big and long-term investment projects. These may include purchase of a property, equipment acquisition and so on. As such, long-term small business loans generally carry a large amount and are repaid over at least three years.
Short-term loans, on the other hand, offer smaller amounts. That’s because they are meant for immediate capital needs like employee salaries and inventory needs. For that reason, short-term loans are also called working capital loans. They typically carry a term of between six months and three years.
Contrary to a loan which offers a lump sum amount, a line of credit provides an ongoing pool of cash. It is more like a credit card than a business loan.
The lender allows you to borrow cash up to a predetermined limit. And, you can tap into that pool of cash whenever you need as long as you don’t exceed the set limit. The amount you pay back is available to you again for borrowing.
Small Business Line of Credit Example
Assume that your lender gives you a line of credit worth $1,000. You can draw $300 the first time and then $350 the second. At that point, the value of your debt will be $650. But your pool will remain with $350 that you can still use.
Let’s say you choose to pay $200 so that the value of debt reduces to $450. In which case that $200 will be available to you again for borrowing. Thus, your pool will have $550 that you can borrow. This process of borrowing and repaying is what makes a line of credit revolving or continuous.
The above example is highly simplified. It doesn’t take into account the interest charged on a small business line of credit. Usually, interest starts to accumulate the moment you draw funds.
It’s also worth mentioning that a business line of credit is subject to annual review and renewal, pretty much like a credit card (but typically with lower interest rates).
Differences Between Business Lines of Credit and Loans
Simply put, a small business loan is a lump sum amount. It’s great when you need to invest in large business projects.
To the contrary, a line of credit is continuous credit (or revolving credit) that allows you to carry an accrued balance. If you don’t use it, then you won’t have to make any payments.
Here’s an even better lowdown on small business line of credit vs loan. We look at how they compare and contrast as well as the pros and cons of each.
You can get a small business loan from community banks, commercial banks, online lenders and some alternative lenders like fintech firms. Small businesses that have been in operation for a considerable period can get SBA-backed loans. These are usually guaranteed by the Small Business Administration (SBA) but are offered by approved lenders like banks.
Similarly, small business lines of credit are offered by banks, online lenders and fintech companies. The SBA also has a small business line of credit called CAPLines.
Ease of Access
Small business loans are generally harder to get compared to small business lines of credit. That’s because lenders have stricter approval criteria for loans.
Oftentimes you’ll need to provide incorporation documents, bank statements, financial statements, contract documents, and a business plan before you’re even considered for a loan.
SBA loans and bank loans are especially the hardest to qualify for, particularly for small businesses. Lenders will go even further and check your business credit history as well as your personal credit.
The same can’t be said for a small business line of credit. For that reason, qualifying for a line of credit is generally not difficult.
That said, some lenders often require that your business is at least 6 months old. Some will also need you to prove that it is a profitable business.
Small business loans are generally larger compared to lines of credit. While not set in stone, you can qualify for a loan amount of anywhere between $500 and $5,000,000.
Small business lines of credit don’t go that high. They often max out at $500,000. As a small business owner, you’ll typically get approved for a much smaller amount than that.
Unlike personal loans, a business owner can only use a business loan for a specifically stated business purpose. For example, you can’t use cash for an equipment loan to purchase inventory or pay employees.
A business line of credit does not limit what you can do with the money. You can, therefore, use it as working capital as well as for emergency situations.
Interest rates on small business loans are not so different from those of lines of credit. In both cases, they typically start in the 3% region and rise all through 25% or even more. It all depends on the lender, loan amount and – in some cases – your creditworthiness.
However, business loans usually come with a fixed interest rate. That means it won’t change over the period of the loan. That can be a good thing because you have a predictable amount to pay each month.
Credit lines have variable rates. If, for example, you make a late payment, your lender may punish you with a higher rate. The good news is that you only pay interest on the amount borrowed, not the set limit.
Period of Availability
A business line of credit provides you with ongoing access to a pool of money. A loan, on its part, is a one-time disbursement of a cash that occurs at the beginning of the agreement.
As already mentioned, you won’t have to pay for a line of credit that you haven’t used. But you’re obligated to repay the amount that you have used. Thus, if you have a line of credit of $20,000 and you only use $12,000, then your repayable debt will be $12,000; not $20,000.
Most lines of credit have a repayment term of one to three years. Whenever your billing cycle comes around, you can opt to pay the entire debt or make a partial payment. In case of the latter, the remaining balance will carry over to the next billing cycle. Keep in mind that interest will be charged on any amount that you carry over.
And you can also pay at your own pace provided you don’t exceed the set maximum date of payment. This is more or less similar to how you would manage a credit card.
Repayment of a business loan is different from a line of credit. Rather than paying at your own pace, you’ll be required to make consistent, periodic payments. This is often on a monthly basis. Thus, every month you’ll be obligated to make a loan payment, which includes interest.
One of the biggest advantages of a business line of credit is that it’s typically offered as an unsecured credit. That means you won’t have to offer any collateral. But this varies from lender to lender, so make sure to shop around for a line of credit that suits your needs.
Loans, on the other hand, always require collateral. You may be asked to put up machinery, accounts receivable, inventory etc. as collateral. In some cases, the lender may require that you include personal property like your house.
Which Is Best for Your Business, Loan or Line of Credit?
That strongly depends on why you need the credit in the first place. It makes more sense to pick a small business line of credit if:
· The amount you need is less than $250,000.
· You need funds that don’t come with restrictions on how to spend.
· You don’t mind an adjustable (variable) interest rate.
· Your business and personal credit histories are less-than-decent.
· You don’t have collateral for the credit.
The flipside is true. A small business loan is more appropriate if:
· The amount you need exceeds $250,000.
· You need the credit for a very specific purpose, like purchase of equipment.
· You prefer predictable payments that come with a fixed interest rate.
· Your business and personal credit histories are stellar.
· You have sufficient collateral to leverage a good interest rate.