A line of credit and term loans are financial tools that provide businesses with the capital they need to grow, manage cash flow, and meet daily operational expenses. A line of credit offers flexible access to funds, while a term loan provides a lump sum that is repaid over a set period.
Key Differences Between Line of Credit and Term Loans
| Basis | Line of Credit | Term Loans |
| Structure | A revolving account that lets businesses borrow, repay, and borrow again up to a set limit. | A lump sum of money is provided upfront, with a fixed repayment schedule. |
| Use | Ideal for short-term, recurrent expenses like payroll or inventory. It’s also a buffer for cash flow fluctuations. | Best for larger, long-term investments like business expansion, equipment purchase, or substantial capital investments. |
| Repayment | Usually, interest is charged only on the borrowed amount. The capital can be repaid and borrowed again. | Regular payments, including principal and interest, are made over a fixed period (term). Once repaid, the loan ends. |
| Interest Rates | Typically variable, changing with market conditions. | Usually fixed, but can be variable. The rate is set at the time of borrowing. |
| Access to Funds | Funds can be drawn whenever needed, up to the credit limit. | Funds are received in a single lump sum at the beginning. |
When evaluating a line of credit vs term loan, businesses quickly realize that they are suitable for different purposes. For example a renovation or large inventory purchase is best financed by a term loan. On the other hand recurring payments like payroll, utilities, or unforeseen expenses are best handled by a line of credit.
Pros and Cons Between Line of Credit and Term Loans
| Criteria | Line of Credit: Pros | Line of Credit: Cons | Term Loan: Pros | Term Loan: Cons |
| Interest Rates | Typically lower interest rates, as it’s only charged on the amount used. | Variable rates can increase, raising borrowing costs. | Fixed rates make budgeting easier as the repayment amount stays the same. | Interest is charged on the full loan amount, even if you don’t use all the funds. |
| Fees | May include annual fees or transaction fees. | Overdraft fees may apply if you exceed your credit limit. | One-time origination fee is common. | Prepayment penalties may apply |
| Flexibility | Funds can be used as needed. | Over-reliance on the credit line can lead to high debts. | Good for large, one-time investments. | Cannot re-borrow funds once they are repaid. |
| Risk | Only borrow what you need. | Risk of overspending due to the revolving nature of the credit. | Fixed repayment schedules can help with financial planning. | Risk of not being able to meet the fixed repayments, leading to default. |
Applicants comparing a business term loan vs line of credit should weigh the factors against specific business needs. While the flexibility of a line of credit can be appealing in comparison to the rigidity of the business term loan, the tradeoff is usually higher costs and lower borrowing limits.
Line of Credit vs. Term Loans: When to Use Each Option
A line of credit is generally best for handling short-term, recurring expenses, or when a business experiences unpredictable cash flow. It serves as a financial cushion, allowing you to cover operational costs like payroll, inventory, or unexpected expenses. The flexibility of a line of credit can be particularly beneficial for businesses with seasonal income or those that frequently need to cover unexpected costs.
On the other hand, a term loan is often more suitable for substantial, one-time investments. This can include business expansion, purchasing equipment, or other capital investments. Term loans offer stability with fixed repayment terms and interest rates, which can help businesses plan their finances more effectively. It’s a good option when you have a clear plan for the funds and can predict the return on investment.
Line of Credit vs. Term Loans: Where to Use Each One
The best times to use a line of credit are:
- Short-term cash flow gaps: A line of credit can help businesses manage cash flow gaps due to delayed payments or seasonal fluctuations.
- Inventory purchases: Businesses that need to purchase inventory before a busy season can use a line of credit to make those purchases.
- Emergency expenses: A line of credit can serve as a safety net for unexpected expenses, like urgent repairs or unplanned operational costs.
The best times to use a term loan are:
- Large capital investments: A term loan can fund significant investments, such as opening a new location or buying a piece of expensive equipment.
- Business expansion: If a business is looking to expand or scale, a term loan can provide the large amount of capital needed.
- Refinancing or consolidating debt: Term loans can be used to refinance existing high-interest debt into a loan with lower interest.
The Bottom Line
Choosing between a line of credit and a term loan ultimately depends on your specific business needs. A line of credit offers flexibility and is ideal for covering short-term expenses, while term loans provide a substantial lump sum that’s better suited for large, one-time investments.
Understanding the differences between a term loan and line of credit and being clear about your financial needs can guide you to the right choice for your business. If you’re looking to compare your options and see what you qualify for, complete our digital application to get started.
Disclaimer: The information and insights in this article are provided for informational purposes only, and do not constitute financial, legal, tax, business or personal advice from National Business Capital and the author. Do not rely on this information as advice and please consult with your financial advisor, accountant and/or attorney before making any decisions. If you rely solely on this information it is at your own risk. The information is true and accurate to the best of our knowledge, but there may be errors, omissions, or mistakes.
Frequently Asked Questions
What is better: A term loan or line of credit?
It depends on your business needs. A line of credit is better for short-term, recurring expenses, while a term loan is better for larger, one-time investments.
What is the difference between a revolving line of credit and term loan?
A revolving line of credit allows you to continuously borrow and repay up to your credit limit, while a term loan provides a lump sum that is repaid over a set period.
What are the interest rates for each type of loan?
Interest rates vary by lender and the borrower’s creditworthiness, but generally, lines of credit have variable rates, while term loans have fixed rates.
How long does it take to get approved for each type of loan?
Approval times vary, but typically, lines of credit may have faster approval times than term loans due to the smaller amounts involved. However, it really depends on the lender you’re working with. Banks can take up to 90 days to respond to an application, whereas non-bank lenders can return a decision in a few hours.
How much can I borrow with each type of loan?
The borrowing limit for a line of credit is usually lower than that for a term loan. Exact amounts depend on various factors, including your credit score, business revenue, and the lender’s policies. However, lines of credit generally carry lower funding amounts than term loans.