Weigh these five must-know factors before choosing between a business line of credit or a business term loan
When your business needs funding, you’ll have a long list of loan types to consider. Often, business owners find themselves deciding between a business line of credit (LOC) or term loan. A line of credit lets you borrow as needed, only paying interest on what you use. A term loan gives you a lump sum with fixed monthly payments. One offers more flexibility for ongoing expenses, while the other provides stability for big investments.
The best business loan for you comes down to your business’s needs, cash flow, eligibility, and future plans. Here are five key considerations to help you decide which option makes the most sense for your business.
1. Flexibility and access to funds
A business line of credit works sort of like a credit card. You can borrow money as needed, up to your approved credit limit, and repay it over time. You’ll only pay interest on what you borrow, and once you pay it back, those funds become available to use again. This structure makes a line of credit more flexible than a term loan, making it a great option for ongoing expenses or situations where you’re unsure of the exact cost of a project or investment.
Term loans offer a fixed lump-sum amount of up to 5 million in some cases. You’ll repay what you borrowed, plus interest in fixed monthly installments. These are good for one-time expenses where you have a clear idea of the cost — think expansion or purchasing inventory.
If you have unpredictable cash flow or you’re unsure of a project’s total cost, a business line of credit may be your best option. But, if you need to make a major purchase or prefer predictable monthly payments, a business term loan may be the right fit.
2. Interest rates and fees
With a business line of credit, interest is only charged on the amount you borrow. However, rates may run higher with a business line of credit compared to a term loan, with rates ranging from 8% to over 60%. Business lines of credit may also come with more ongoing fees. For example, you may be on the hook for origination fees, draw fees, maintenance or annual fees, late payment fees, and, in some cases, inactivity fees. But, this varies by lender.
Term loans offer fixed interest rates with predictable monthly payments. Rates are generally around 8% to 36%. Fees vary by lender, but you could be charged origination fees, prepayment penalties, or late payment fees.
Both types of loans reserve the best interest rates for established businesses with good credit. A term loan may be a cheaper option for long-term financing, while a line of credit is more cost-effective for short-term needs.
3. Eligibility
A business line of credit typically requires at least a year in business, decent credit around the mid-600s, and meeting the lender’s minimum annual revenue requirement.
A term loan typically requires at least two years in business, meeting a minimum annual revenue requirement and a good credit score around mid-600. However, a score of around 700+ offers you the best chance of getting the most favorable loan terms. Some lenders may require collateral or a personal guarantee before approval, especially for higher loan amounts.
Business lines of credit generally have a bit more relaxed eligibility requirements than a term loan. But, term loans typically offer higher loan amounts and lower interest rates. So, which one will work best depends on what you need and if you can meet the lender’s requirements.
4. Repayment terms and loan structure
With business lines of credit, you typically make periodic repayments only on what you’ve borrowed — and you’ll only pay interest on that amount. As you pay back the borrowed amount, your available credit is replenished, allowing you to borrow again.
Term loans come with fixed monthly payments with a set repayment schedule. You’ll pay interest on the entire loan amount. And, if you need more money, you’ll have to apply for another loan.
A term loan provides a predictable repayment schedule, which may be easier to budget for. However, a line of credit offers borrowing and repayment flexibility, which may benefit some business owners.
5. What you plan to use the loan for
Business lines of credit are best for ongoing or unpredictable expenses. They make the most sense for flexible, short-term funding when expenses fluctuate. Seasonal businesses, industries that experience unpredictable cash flow, or projects without a defined cost may benefit from an LOC, for example, covering payroll or emergency repairs.
Terms loans make the most sense for large, one-time investments. These loans can cover big-ticket expenses where you need a large sum upfront and can comfortably afford the fixed monthly payments. Established businesses with a specific project in mind and a clear return on investment might lean towards a business term loan. Some examples include buying equipment, hiring staff or expanding your business by opening a new location or remodeling.
Wrap up
When you’re ready to apply for a business loan, knowing the key differences between a line of credit and a term loan can help you make the best choice for your business. If you need flexibility for ongoing expenses, a line of credit might be the right fit. But, if you’re planning a major one-time investment and want the stability of fixed monthly payments, a term loan may work better.
