by Meredith Wood
When it comes to operating and growing a business, having access to cash is a necessity. However, if you don’t have the extra cash lying around, you’ll have to look for financing elsewhere, but the question is: where? Are you interested in applying for a more traditional loan, such as a term loan, or do you need something with a little more flexibility, such as a business line of credit?
Both a term loan and a business line of credit are great financial tools for entrepreneurs—but how does each one work, and which one is better for your business? Let’s dive right in.
Business line of credit
Much like a credit card, a business line of credit can come in handy when you’re in a pinch and need extra cash—fast. Business credit cards, however, tend to have higher interest rates and charge additional fees for cash advances, but the concept is similar. You’re allocated a set limit of financing that you can access at your leisure, and you accrue interest only on the money you pull from your line.
For example, let’s say you have a line of credit for $10,000 and you need $5,000 to replace a bad batch of inventory; you’re only required to pay back the $5,000 you borrowed, plus interest. So if the interest were set at 10 percent, you’d owe a total of $5,500 (or $5,000 plus $500 in interest).
The other huge benefit to a line of credit is that it’s “revolving.” So once you’ve repaid your debt, you’ll have access to the full $10,000 without reapplying. You’re able to draw and repay funds as you wish, so long as you don’t go over your credit limit.
A business line of credit can be secured with inventory, receivables or other collateral, but the most commons lines of credit are typically unsecured debt.
When does a business line of credit make sense?
Think of a business line of credit as more of a safety net. Since there’s typically no operating charge for a line of credit, it’s best to apply for one when you don’t actually need it, so when you do, you won’t have any setbacks.
A business line of credit is best used for short-term financing needs and operating expenses like payroll, temporary cash flow shortages, and so on. While you can use the money for a long-term investment, it’s best to not tie up your credit line, so when an emergency does arise, you’ll have it at your disposal.
Term loans are a little stricter when it comes to how they operate. As opposed to borrowing and repaying as you go, a term loan is given in one lump sum payment, and is repaid within a specific time frame, or term (short, medium, or long).
Also unlike a business line of credit, you must begin repaying a term loan as soon as you get it, and once the loan funds are gone, you’ll need to reapply for a new one.
The nice thing about a term loan is that they come in different shapes and sizes and there are options for creditworthy businesses, as well as those who may be younger and still building their financial and credit history. As well, since a term loan is a transaction and a line of credit is continuous, they tend to be a bit easier to qualify for.
When does a term loan make sense?
A term loan can be used to meet virtually any business need, like working capital and paying back other debts, but works best when used for more long-term investments, such as new equipment or expansion.
It’s important that what you plan to purchase will help increase your sales and profits, ensuring you have what it takes to pay back the loan, and can clearly see this as a good investment in your business.
It all comes down to the type of credit line or loan you’re looking at. Keep in mind the longer you’ve been in business, the higher your revenue, and the better your credit score, the more likely you are to qualify for either product. Your interest rate and the amount you can borrow will also vary dramatically depending on these and other qualifications.
Regardless of which business loan product you choose, always shop around and compare APRs. At the end of the day, the best product for your business is the lowest cost one.
Meredith Wood is the editor-in-chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. She is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more.