Which Financing Option Is Best for Your Small Business – a Line of Credit or a Term Loan?

If you need financing for your business, you have several options. A line of credit and a term loan are two popular options. To decide which is right for your business, you need a clear understanding of each option, how they work and how they differ.

"A term loan provides funds upfront and comes with a set repayment plan," said Randall Yates, CEO of The Lenders Network. "A line of credit works similar to a credit card, where you are given a line of credit you can borrow from as needed."

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What is a line of credit? 

A line of credit (also known as an LOC) is an arrangement between a bank or financial institution and an individual that establishes a maximum amount of money the borrower can access or maintain. 

You can access funds from your line of credit at any time, as long as you don't exceed the maximum amount specified in the loan agreement and you meet all the requirements set by the financial institution, like making timely minimum payments.

Key features of a line of credit

1. Flexible borrowing: An LOC offers the flexibility to borrow the amount of money you need at any time, as long as it's within your credit limit.
2. No fixed terms: An LOC does not require you to make monthly payments on your outstanding balance; instead, you can make minimum payments each month, make bigger payments or pay off your total balance if you choose.
3. Variable interest rates: This feature can be tricky. If interest rates go down, it's cheaper to borrow money (within the limits of your line of credit). However, if interest rates go up, it costs you more money to borrow and repay your outstanding balance.

Did you know? With a line of credit, the interest rate tends to be variable, which means it changes with the prevailing rates in the market. When interest rates are low, you pay less. When they go up, so does your payment.

When can you use a line of credit?

Let's look at two scenarios where using a line of credit may be ideal:

• Your small business has just completed several projects, and your next batch of receivables is due in a week. However, you need to pay 10 of your employees in the next four days and don't have any cash. In such a scenario, you could use an LOC to cover payroll, then pay it back as soon as your receivables come in.
  
  
• You sell numerous products from a kiosk, and one of them is selling faster than you anticipated. You urgently need to order more, and your supplier is willing to offer a great deal on the product, but it requires cash on delivery. You could use an LOC to pay for the product, then repay it after you've received your inventory.

Which businesses should use a line of credit? 

A business line of credit can be used by any small business owner who wants access to money they can draw down when needed. It makes the most sense for business owners in a good financial position. The better your credit score, the lower the interest rate you'll get on your line of credit. In our review of Fundbox, a top business lender, we found that its lines of credit require businesses to have a credit score of at least 600 and $100,000 in annual sales. Businesses also must have been in operation for at least six months.

FYI: In our research of the best business loans, we found many alternative lenders will extend lines of credit to business borrowers. They all have different requirements for credit scores, years in business and annual sales.

What is a HELOC?

A home equity line of credit, or HELOC, is a line of credit given to a borrower using the equity they have in their home as collateral, Yates explained. A HELOC allows you to borrow up to 80% of the market value of your home.

"It acts like a credit card where a limit is established that you can borrow from on a regular basis," added Tyler Forte, CEO of real estate brokerage Felix Homes. "Since the property is collateral, the credit limit is higher than credit cards and the interest is generally lower."

The good thing about a HELOC is that there is usually no commitment fee, according to Rob Stephens, CPA and founder of CFO Perspective.

"They have a draw period of five to 10 years, during which they are revolving lines of credit," Stephens said. "One way they're better than a business line is that there are no resting requirements."

Which businesses should use a HELOC? 

Typically, startups or businesses in the early stages that need capital will use a home equity line of credit to fund their operations. Once they are more established, they usually turn to different funding options for capital. 

Revolving line of credit vs. business credit card

According to Stephens, credit cards are usually unsecured, and you can't borrow as much as you can with a revolving line of credit. He said they are made for small purchases.

Yates added that credit cards have higher interest rates than revolving lines of credit.

"Revolving lines of credit may be unsecured or secured by inventory or accounts receivable," he said. "You can usually get a much bigger line of credit than you can get with a credit card."

Business credit cards are one of the most common forms of revolving lines of credit for businesses, according to Forte. 

Why should you choose a line of credit?

Justin Nabity, founder and CEO of financial planning firm Physicians Thrive, gave two good reasons for choosing a line of credit:

1. It helps cash flow. A line of credit allows you to get the cash you need when you need it. In this way, when you have slow seasons when money isn't flowing in, a line of credit can help you even out your cash flow and stay in business.
2. You pay only for your use. Since you borrow money from a line of credit only when you need it, you only have to repay the lender for the amount you borrowed. If you don't borrow a lot, you won't accrue much interest. Also, depending on the lender, you can pay back the amount a lot sooner.

What is a term loan?

A term loan is a bank loan for a specific amount that has a specified repayment schedule and a fixed or floating interest rate. Numerous banks offer term loans to small businesses so that they have the cash they need to operate from month to month. If you have a small business, you can use the money from a term loan to purchase fixed assets, such as equipment for production processes. 

Key features of a term loan

1. Fixed terms: A term loan often has a fixed interest rate and a set repayment period. With this type of financing, you have a clearer picture of how much interest you will pay over the life of the loan, and you know what your payments are.
2. Secured and unsecured term loans: Your bank or credit union may require you to put up collateral as a way of securing the loan in case you fail to repay. Collateral can be your house or car. When you opt for a secured term loan, you typically pay a lower interest rate than you would for an unsecured term loan, but if you don't repay the loan, your personal assets are at risk.

Did you know? Banks aren't the only ones offering term loans. A variety of alternative lenders provide short- and long-term financing to businesses.

When can you use a term loan?

Here are some scenarios where a small business might want a term loan:

• You need to buy new computers for your office staff of 40. Computers have an average lifespan of three years, so you could opt for a three-year term loan.
  
  
• You own a restaurant and are looking to expand. You need new equipment to scale up. It will take you quite some time to pay for everything you need for this expansion. Usually, kitchen equipment can be used for up to 10 years, which allows you to stretch out the repayment term to a decade.

Which businesses use term loans? 

Term loans are a common form of business funding and are popular with businesses of all sizes. You need to have an established business and some sales to get approved. The best term loan lenders offer flexible terms and fast funding. Learn more about a top option in our full review of SBG Funding. 

Small business term loan vs. line of credit

Imani Francies, financial expert with US Insurance Agents, provided some information on the key differences between small business loans and lines of credit.

For big one-time purchases – such as new equipment, significant capital-intensive investments or new facilities – a term loan might be more useful. On the other hand, a line of credit, which is comparable to a credit card, is more flexible and intended for everyday expenses to keep your business afloat. 

Depending on whether you need to spend big or small, choose the credit option that best suits your needs. However, before agreeing to any loan, closely review the loan agreement and make sure you clearly understand the details.

Shiv Nanda and Jennifer Post contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.