Business Line of Credit vs. Term Loan

Running a business can often mean needing capital beyond what you have on hand. The right type of financing can help you maintain operations and invest in growth opportunities. Two of the most common business financing options are a business line of credit and a business term loan.

However, there are some major differences between the two. Understanding how each of these types of business credit works can help you decide which is right for your small business.

Business line of credit vs. term loan: what’s the difference?

How does a business line of credit work?

A business line of credit is a flexible business funding option. It allows you to draw funds as needed, up to a set credit limit, and interest is only charged on the amount you borrow. You’ll repay by making regular payments against the outstanding balance — it works similarly to a business credit card because they’re both types of revolving credit. Many small business owners use a line of credit to fund things like ongoing growth initiatives or short-term cash flow gaps.

How does a business term loan work?

A business term loan is a type of loan that offers borrowers an upfront lump sum of cash. These can be short-term loans or long-term loans. Either way, the borrowed funds are repaid over a specific period of time, generally in equal installments. Many business owners apply for term loans to cover a specific business need — usually large, one-time expenses like purchasing equipment.

What are the pros and cons of business lines of credit?

Pros

Flexibility. One of the biggest advantages of a line of credit is the flexibility. You have access to a set amount of funds, but you only pay interest on the amount you use. You can take a draw whenever you need, making a line of credit helpful for managing working capital and unforeseen business expenses.

No collateral. Many lines of credit are unsecured. This can make them more accessible to small businesses and startups that lack substantial assets. While an unsecured line of credit may require the owner to make a personal guarantee, there’s no need to have an item of value to secure the credit.

Quick access to funds. A business line of credit is a great tool for taking care of short-term cash flow gaps and seasonal fluctuations. You can withdraw the funds from your line of credit whenever you need, as long as you haven’t reached your credit limit. Meaning you can have funds in your account sooner than you would if you had to reapply for a business loan.

Cons

Variable interest rates. Many lines of credit come with variable interest rates. This can mean lower interest rates at first, but if interest rates go up the cost of borrowing will increase.

Potential to overspend. Because a line of credit makes it easy to access and borrow money, it can be tempting to overuse it. Borrowing too much can cause financial strain which can affect your ability to repay. Missing payments can damage your credit score and affect your overall creditworthiness.

Maintenance fees. Some lenders may charge annual or monthly fees for maintaining a business line of credit, even if you don’t actively use it. These fees can add to the cost of borrowing, so it’s important to factor them into your financial decisions.

What are the pros and cons of business term loans?

Pros

Predictable payments. Term loans typically have fixed repayment schedules that can make it easier to work your loan payments into your budget. This can make repayment a bit easier to manage. Consistent on-time payments can help you build a positive credit history.

Fixed interest rates. Term loans typically offer fixed rates. This means your interest rate remains constant throughout the loan’s term, making it easier to plan for and budget your monthly expenses. In contrast, other forms of small business financing may have variable interest rates that can change over time, potentially leading to uncertainty in your repayment amounts.

Larger loan amounts. Term loans typically offer a larger amount of money than a line of credit. This can be helpful to businesses that need a significant amount of working capital.

Cons

May need collateral. Many term loans require collateral to secure the loan. In the case of equipment loans, the equipment itself may act as collateral. In other cases, you may need to use business assets to secure the loan and get approved.

Less flexibility. Some types of small business loans can only be used for a specific purpose. For example, commercial real estate loans can help you buy a new location, but you can’t use the money to pay bills during a slow month.

Interest costs. While term loans can have lower interest rates, paying interest over the entire loan term can result in higher overall interest costs compared to shorter-term financing options. If you opt for a longer repayment term, you may end up paying more in interest over the life of the loan.

When should you use a business line of credit?

While it always depends on your unique financial situation, you may want to consider a line of credit if your business has one of these needs:

Seasonal fluctuations. If you run a seasonal business, you’ve probably had to manage big swings in your cash flow. A line of credit can help make it a little smoother. During the busy season, you can use your line of credit to cover the increased operational costs or inventory purchases, and during the slower months you can use it to cover cash flow gaps.

Short-term expenses. Line of credit are great for addressing short-term financial needs, such as covering payroll, paying suppliers or handling unexpected costs like repairs or maintenance. Instead of dipping into your cash reserves or disrupting operations, you can draw from your line of credit.

Scaling up. Growing your business may require you to have some additional working capital on hand. A line of credit can help provide the funding you need to hire staff, invest in marketing or expand your product line.

When should you use a business term loan?

Whether or not a term loan is right for your business depends on your financial situation. However, term loans may be helpful if your business has one of the following needs:

Large investments. Business term loans can be great when you need a significant loan amount upfront for a specific purpose. These often include equipment purchases, real estate acquisitions, renovations and expansions.

Fixed project costs. If you’re taking on a new project or making a new investment and know how much it’s going to cost, then a business term loan can be helpful. Because of their predictable payment schedule, it’s easier to budget and it can help you allocate resources more efficiently.

Debt consolidation. If your business has credit card debt or multiple high-interest loans, a term loan can be used to consolidate it into a single loan with a potentially lower interest rate. Debt consolidation can help streamline your finances and help save you interest over time.

Can you have a business line of credit and a business term loan at the same time?

Yes, you can have a business line of credit and term loan at the same time. Some small business owners find this to be a great strategy for them. They use the term loan for long-term investments, and rely on the line of credit for short-term working capital needs.

Where can you get lines of credit and business term loans?

Banks and credit unions. Traditional financial institutions such as banks and credit unions often offer loan options for small businesses. However, they often have very strict eligibility requirements and the process can take a lot longer than alternative lenders.

Online lenders. Online business lenders are popular because of their speed and accessibility. They cater to a wide range of businesses, and while they may have higher interest rates they’re often willing to work with those the banks may have turned away.

Small Business Administration (SBA). While technically not a lender, the SBA offers government-backed programs designed to support small businesses. However, SBA loan guarantees often involve a more extensive and lengthy approval process, making it more difficult to get business funding quickly.