As a small business owner, accessing financing is a crucial part of growth and stability. However, choosing the right type of loan can be confusing. Two of the most common options — term loans and lines of credit — serve different purposes and can impact your financial health in distinct ways. Understanding the differences will help you make an informed decision that aligns with your business needs.
What’s a term loan?
A term loan is a lump sum of money provided upfront that you repay in fixed monthly installments over a set period. These loans typically have a fixed interest rate, meaning your payments remain consistent throughout the term.
Best uses for a term loan:
Best uses for a term loan:
- Purchasing new or used equipment.
- Financing a business vehicle.
- Reconsolidating existing business debt.
- Purchasing commercial real estate.
- Specific business item purchases.
- Fixed repayment schedule: Predictable monthly payments help with budgeting.
- Lower interest rates: Often lower than lines of credit because they’re structured for long-term investments.
- Secured or unsecured: Can be backed by collateral (secured), such as equipment or real estate, or granted without collateral (unsecured) based on creditworthiness.
What is a line of credit?
A business line of credit is a flexible financing option that allows you to borrow up to a set limit, repay it, and borrow again as needed. It works similarly to a credit card, providing access to funds when necessary rather than a lump sum upfront.
Best uses for a line of credit:
- Working capital needs.
- Operating expenses.
- Covering short-term cash flow gaps.
- Managing seasonal fluctuations in revenue.
- Handling unexpected expenses.
- Payroll.
- Revolving credit: Borrow and repay multiple times within the limit.
- Variable interest rates: Rates fluctuate and are often higher than term loans, as the lender assumes more risk.
- Interest-only payments possible: Some lenders allow payments covering only the interest for a period, reducing short-term costs.
How to choose the right option for your business.
The choice between a term loan and a line of credit depends on how you plan to use the funds.
- If you need a one-time investment (e.g., purchasing equipment or acquiring a building), a term loan is usually the better option due to its lower interest rate and structured repayment.
- If you need ongoing access to funds to manage cash flow fluctuations, a line of credit provides flexibility and convenience.
Avoiding common mistakes.
A frequent mistake made by business owners is using a line of credit for long-term expenses. While it may seem convenient, the higher interest rates and variable nature of a line of credit can lead to higher overall costs. Likewise, using a term loan for short-term operational costs can create unnecessary financial strain due to fixed monthly payments.
Final thoughts.
Understanding the difference between a term loan and a line of credit ensures you choose the right financing tool for your business. By considering the purpose of the loan, the repayment structure, and the overall costs, you can make a decision that supports your business’s long-term success.
About the Author
Josh Andrade
AVP / Relationship Manager
Small Business Banking
Spokane, WA