When you’re looking for funding options to help your business grow, a small business term loan is often the answer. But sometimes, a small business line of credit could be a better fit.
This brief guide will help you better understand the differences between a term loan vs. line of credit. You’ll also get the insight you need to decide which option may be best for you now and as your business grows.
Term loan vs. line of credit: What each option offers your business
A term loan is a one-time loan made from a lender to your business. It has a specific principal amount, fixed or variable interest rates, and a set repayment schedule over a set length of time.
Some key points to know about term loans:
- Term loans can be made by just about anyone or any entity: A family member may loan you money, as will a bank, credit union or Community Development Financial Institution (CDFI).
- Banks, credit unions, CDFIs and other lenders will set your loan terms. A responsible lender will ensure that you get the funds you need with terms that you can pay back on time and in full. Most term loans will have a five to 10 year repayment period and competitive interest rates.
- On the other hand, predatory lenders may set unreasonable terms that make it hard to pay back loans. For example, some demand daily payments, some charge extremely high interest rates, and some even do both.
A line of credit is an extension of credit by a lender for a preset maximum amount. You can repeatedly use the line and repay, as long as the line of credit remains in good standing. Keeping your line of credit in good standing means that your payments are made on time and that you haven’t exceeded the credit limit.
Here are the key points you need to know about a line of credit:
- Lines of credit are typically issued by banks and, sometimes, credit unions.
- A business line of credit is like a credit card. It can be used to meet your business’s financial needs, as long as the minimum monthly payment is met. What makes a business line of credit different is the maximum amount tends to be higher than the credit limit on a credit card. Additionally, a line of credit will generally offer lower interest rates than credit cards.
- With a line of credit, you only use what you need up to the maximum limit, and pay that back over time. Small business lines of credit are often set up to allow you to make interest-only payments for a set amount of time with the full balance due at the end.
- With a line of credit, the amount you are required to pay month to month can vary based on how much of the credit line you’ve used, and if the interest rate is variable. The advantage is that you’re not paying for money that you borrowed but haven’t spent.
Term loan vs. line of credit: Which is better for your business’s needs?
Whether a term loan or a line of credit is best for your business depends on how you plan to use the funding.
A good rule of thumb is that the repayment period should align with the life of the goods or services for which it’s used. 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. On the other hand, inventory that you expect to turn around in a matter of weeks or months could be purchased through a line of credit.
Another way to think about it is to compare it to your household expenses: You’d likely use a credit card to cover short-term (or unexpected/unplanned) needs and this is comparable to a business using a line of credit. However, if you’re investing in longer-term assets such as a car, a home, or home renovations, then a term loan (like a mortgage or an auto loan) is a better option.
These questions can help you determine the best option for your business now and in the future:
- Do you need funding to help you with cyclical or seasonal ups and downs? Maybe you’re building up 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 you’re generating more revenue. However, be careful that you don’t take on too much debt so that you’re not facing a cash crunch during your leaner months.
- Do you typically have different expenses at different times? Lines of credit are great for short-term needs and offer more flexibility over time. For example, let’s say your accounts receivable has a 30 to 60 day payment period (meaning that you won’t receive payments from your clients for several weeks or months). Here, a line of credit could help you bridge the gap between billing a client and when you receive payment.
- Are you using the funding for long-term assets, such as equipment and furnishings? Because these items have a longer useful-life expectancy (more than a few years), you’ll want to explore term loans. 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 at once (and possibly retain some for working capital)? A term loan may be the better option for the same reasons as above.
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. Every day, we help entrepreneurs 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 find an option that works best for you now, as well as ways to use small business financing to grow your business and thrive.