Term Loan vs. Line of Credit: Understanding Key Differences

When you’re looking for funding options to grow your business, a small business term loan is often the answer. But sometimes, a small business line of credit could be a better fit.

When you know the differences between a term loan vs. line of credit, you’ll have a better understanding of your funding options. Here’s what you need to know to make the best decision for your business.

What is a term loan?

A term loan is a loan made from a lender to your business. It has a specific principal amount, a fixed or variable interest rate, and a set repayment schedule over a set length of time.

Term loans can be made by just about anyone or any entity. You can borrow money from a bank, credit union, Community Development Financial Institution (CDFI), or even a family member.

Banks, credit unions, CDFIs, and other lenders will set your loan terms, including the interest rate and repayment period. A responsible lender will make sure that your loan works for you now and in the future by approving the right amount of funding for your business with terms that allow you to fully repay the loan on time. Most term loans have a five to 10 year repayment period and interest rates in line with market rate and the risk of the loan.

Watch out for predatory lenders who may set unreasonable terms that make it hard to pay back your loans. For example, some require daily payments, others charge extremely high interest rates, and some even do both.

What is a line of credit?

A line of credit is an extension of credit by a lender for a preset maximum amount for a shorter period of time (generally 12 to 24 months). You can apply for a line of credit with a bank or some credit unions.

While the line of credit is active, you can repeatedly borrow and repay up to the maximum credit limit. You’ll just need to keep the line in good standing with your lender by making your payments on time and staying within your credit limit.

While a business line of credit is similar to a credit card, lines of credit tend to have a higher credit limit and a lower interest rate. They might also be set up so you can make interest-only payments for a set amount of time with your full balance due at the end of its term (also known as a clean-up period).

Your monthly payment can vary based on how much of the credit line you’ve used and if it has a variable interest rate. The advantage is that you’re not paying for money that you borrowed but haven’t spent.

At the end of your term, there are three paths forward: your line could be renewed, it could be “termed out,” or it might be closed.

If you want to renew your line, talk to your lender before the term ends to find out what you’ll need to do to get approved. There may be a renewal fee, so ask your lender what to expect before you renew. Depending on how the fee is charged, you may have a balance on your line at the start of your term, which will accrue interest until you pay it.

If your lender recommends “terming out” your line at the end, they’ll refinance the remaining balance into a term loan. This can be beneficial since term loans can have lower interest rates than lines of credit. Since you’ll be paying down the principal and interest each month, your monthly payments will be different than they were with your line of credit.

Your line also might be closed once the term is finished depending on your needs and your lender’s discretion.

Term loan vs. line of credit: Which is better for your business’s needs?

Deciding between a term loan and a line of credit comes down to how you’ll use the funding. You want to make sure that your repayment period aligns with the life of the goods or services you’re financing. For example, a piece of equipment that’s expected to last for five years should be funded through a loan with a similar repayment period.

However, if you’re purchasing inventory that will generate revenue in a matter of weeks, a line of credit might be a better fit. You can also use lines of credit to cover your accounts receivables.

Answering these questions can help you determine the best option for your business :

  • Do you need funding to help you with cyclical or seasonal ups and downs? Are you building up your inventory prior to the holiday season or restocking a kitchen to open a summertime restaurant? A line of credit would be a good option for these needs. It gives you the capital you need now, and you can pay it down when your business is generating more revenue. 
  • Do you typically have a cash flow crunsh? Lines of credit are great for short-term needs and offer more flexibility over time. Are your suppliers asking you to pay them in 15 to 30 days while your customers pay you in 30 to 45 days? A line of credit is great for bridging short-term gaps and offers more flexibility over time.
  • Are you using the funding for long-term assets like equipment and furnishings? These items have a longer useful-life expectancy (more than a few years), so you’ll want to explore term loans for financing. With a term loan, you can get fixed rates and fixed payments over a longer repayment period.
  • Are you planning to use most of the funds for a specific need and keep the rest for working capital? A term loan may be the better option for the same reasons as above.

Create cash flow projections to maximize your line of credit

Before you apply for a line of credit, you should know how your business’s cash flow varies over time. The best way to understand it is to create a cash flow projection, which allows you to see how money comes into and out of your business on a month-to-month basis.

In the months where more cash is going out than coming in, a cash flow projection will show you how much you’ll need to pull from your line of credit and how much interest you’ll be charged. 

In the months where more cash is coming in, you can determine how much you’ll use to pay down your line of credit balance to avoid hitting your limit. This also decreases what you’ll owe during your clean-up period at the end of the line’s term.

Talk to Pursuit, we can help you get the right funding for your business

Pursuit has more than 15 funding options available for small businesses, including a small business line of credit. Every day, we help entrepreneurs like you find the best funding solution to meet their needs, and we can help you, too.

Contact us today to learn more about our term loans and lines of credit and find an option that works best for you now. With the right funding, you’ll find new ways to grow your business and thrive.

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