In this article, I’ll explore how lines of credit and how business loans work, their advantages and disadvantages, and how to determine which can be more suitable for your business's unique situation.
| Line of Credit | Business Loan | |
|---|---|---|
| Access | Revolving line of credit | Receive proceeds when the loan closes |
| Repayment Structure | Payment only if you owe an outstanding balance | Fixed monthly payment |
| Repayment Terms | Based on the amount you owe | Repaid over a predetermined period |
| Fees | No origination fees – But, may include other fees like maintenance or draw fees, depending on the lender | Origination fees |
Great for | Source of working capital | Long-term capital costs |
What Is a Line of Credit?
A line of credit is a flexible financing option that allows businesses to borrow funds up to a predetermined limit, as needed, rather than receiving a lump sum all at once. Similar to a credit card, it provides revolving access to funds, meaning you can draw from the line, repay, and borrow again.
For example, if the lender requires that you make monthly payments equal to 2% of the outstanding line balance, and you owe $10,000, your monthly payment will be $200. If you take an additional draw of $5,000, raising your balance to $15,000, your monthly payment will be recalculated at $300 per month.
This type of financing is suitable for managing short-term cash flow needs, covering unexpected expenses, or handling working capital fluctuations. You only pay interest on the amount you borrow, and payments vary based on your outstanding balance, offering flexibility in repayment.
What Is a Business Loan?
A business loan is a lump-sum financing option where a business receives a specific amount of money upfront to be repaid over a fixed period with regular, often monthly, payments. The loan amount, repayment terms, and interest rate are determined at the time of approval.
Business loans are typically used for significant, long-term investments such as purchasing equipment, expanding operations, or funding large projects. They offer predictable payments but require a commitment to repay the entire loan, including interest, regardless of how the funds are used.
Business loans typically offer lower interest rates than lines of credit. Monthly payments vary based on the borrowed amount and interest rate.
What Are the Differences in Fees Between Line of Credit vs. Loans?
Fees will be different between business loans and lines of credit. In most cases, business loans will come with upfront fees, the most important of which is an origination fee. An origination fee is a one-time charge lenders impose for processing a new loan application. These fees are generally anywhere between 1% and 6% of the business loan amount.
Lines of credit sometimes have origination fees, as well as annual and maintenance fees. This factor depends on the line of credit terms. That being said, lines of credit often charge a draw fee each time you take a draw on the line. Some banks offer flat rates, say $50, but some charge a percentage of the amount drawn. These percentages range usually 1-2% but can be as high as 3%.
What Are the Benefits of a Line of Credit for Businesses?
Flexibility: Access funds as needed rather than receiving a lump sum upfront.
Cash Flow Management: Good for covering short-term cash flow needs, unexpected expenses, or seasonal revenue fluctuations.
Cost Efficiency: Interest is only charged on the amount borrowed, saving on financing costs.
Revolving Access: As you repay, the credit line is replenished, providing continuous access to capital.
Liquidity Maintenance: Ensures ongoing access to funds without the need to reapply for new loans.
Short-Term Capital Needs: Appropriate for operational expenses, inventory purchases, and other temporary financial demands.
What Are the Benefits of a Business Loan?
Wondering why to take a business loan? Here are just a few reasons:
Lump-Sum Funding: Provides a large, upfront sum of money for significant, long-term investments.
Predictable Payments: Fixed repayment terms with regular, consistent payments, making budgeting easier.
Lower Interest Rates: Often comes with lower interest rates compared to revolving credit, especially for longer-term loans.
Structured Repayment Plan: Helps businesses plan for debt repayment over a predetermined period.
Works for Major Expenses: Suitable for funding large capital projects, purchasing equipment, or expanding operations.
No Ongoing Fees: Unlike lines of credit, business loans usually don't incur ongoing fees like maintenance or draw fees.
What Are the Drawbacks of a Line of Credit vs. a Loan?
Line of Credit Cons:
Variable Payments: Monthly payments fluctuate depending on the balance, which can make budgeting unpredictable.
Higher Interest Rates: Lines of credit often carry higher interest rates than business loans, especially for long-term borrowing.
Potential for Overspending: The ease of access can tempt businesses to borrow more than needed, leading to financial strain.
Ongoing Fees: Some lines of credit come with maintenance, draw, or annual fees, adding to the overall cost.
Limited Use for Large Investments: Not ideal for significant, long-term purchases or projects, as borrowing limits are usually lower than loans.
Business Loan Cons:
Fixed Repayment Schedule: Requires consistent monthly payments, which can be challenging if cash flow is unpredictable.
Full Repayment Obligation: Businesses are obligated to repay the entire loan, regardless of whether all the funds were used.
Less Flexibility: Funds are provided in a lump sum, so if the full amount isn't needed, businesses still have to manage and repay the full loan.
Origination Fees: Business loans often come with origination fees that add to the upfront cost.
Longer Approval Process: Applying for a business loan usually involves more paperwork, stricter credit checks, and a longer approval time compared to a line of credit.
How to Determine Which Is Better for Your Business: Line of Credit or Loan?
Identify Your Financing Needs: Determine if you need funds for short-term operational costs (like payroll or inventory) or long-term investments (like equipment or expansion).
Evaluate Cash Flow: If your business experiences cash flow fluctuations, a line of credit offers flexibility. For stable cash flow, a fixed loan might work better.
Consider Repayment Preferences: If you prefer fixed, predictable payments, a business loan may be better. For flexible repayment based on usage, you can choose a line of credit.
Assess Cost and Fees: Compare interest rates, origination fees, and other potential costs. Business loans typically have lower rates, while lines of credit may carry maintenance fees or higher interest rates.
Match Financing with Business Goals: Align the type of financing with your specific business goals, whether it’s working capital or long-term growth investments.
