Term Loan vs. Line of Credit: What’s the Best Fit for Your Small Business?

What is a business term loan?

A term loan is a fixed funding transaction. It is a one-time loan based on the current cash flow of your business (often plus collateral that you pledge to secure the loan). 

With a term loan, all of the proceeds are available at the time of closing. The lender bases your payments, interest, and principal on the amortized loan terms. (For example, your business might take out a $100,000 loan at an 8% fixed interest rate over a 5-year term.) Interest rates and monthly payments on term loans are generally fixed for the life of the loan. 

If your term loan is secured (many are), the bank will assume an ownership position on the collateral you offer. This means you cannot transfer or liquidate the collateral you use to secure the term loan until you make the final loan payment. 

The typical use for a term loan is to finance a major expenditure. This type of funding does not work well, however, as a daily cash flow solution for your business. 

Term loan requirements.

A term loan can be an attractive financing solution due to the fact that well-qualified businesses may be able to secure competitive interest rates and borrowing terms. At the same time, lender qualification criteria for a business term loan may be more challenging to satisfy compared with other types of financing for small businesses.

While every lender is different, here is a general overview of the minimum requirements that your business may need to satisfy in order to qualify for a business term loan. 

• Minimum credit score: 680 or higher
• Monthly revenue: $8,000 and above
• Time in business: at least two years

What is a business line of credit?

A business line of credit (LOC) is a bit like a cross between a short-term business loan and a business credit card. When you open a business LOC, the lender approves you for a credit limit on the account. This credit limit represents the maximum amount of money your business can borrow at a given time. 

As your business uses its credit limit, less money is available to borrow in the future. But your business can repay the money it borrows (plus interest) and regain access to the same credit line, as long as the business LOC remains in good standing and available for active withdrawals. 

As you borrow against the available credit limit, you accrue interest charges each month. You’ll only pay interest on the amount of money withdrawn.Interest rates are often variable and can fluctuate with the market. The monthly payments your business owes on its line of credit may vary each month, as well, based on your balance and current interest rate. 

It’s critical to exercise discipline when you use a business line of credit, just as you should with a business or personal credit card. Your business should apply funds from the revenue it earns each month toward paying down its credit line. There should be a constant flow of money repaying any borrowed funds as customers pay for your goods or services.

In some situations, a lender may convert a maxed-out business LOC into a term loan. If this happens, the borrower must make monthly payments to pay off the old credit line, but the LOC is closed to new transactions. Meanwhile, the business might not be able to access additional funding elsewhere while the loan is outstanding, due to its current debt burden. Access to capital is the lifeblood of any company, and lack of capital has the potential to starve a growing business.

A line of credit has the potential to be a great cash flow management tool. A study by Intuit found that 61% of small businesses face cash management challenges. Other smart uses for a line of credit could include stocking up on discounted inventory, financing for marketing campaigns, and more. Yet business LOCs may not work well as a long-term borrowing solution, due to their potentially high and variable interest rates.

Line of credit requirements.

A business line of credit is a flexible funding resource that can be useful for many small businesses. Interest rates may be higher with LOCs compared to some term loans and other business financing options. But lender qualification standards are often more forgiving as a tradeoff.

Again, each lender sets its own minimum requirements for business line of credit applicants. Here’s an overview of the qualification standards you might need to satisfy. 

• Minimum credit score: 600 or higher
• Annual revenue: $50,000 and above
• Time in business: at least six months

Differences between business line of credit vs. term loan.

Term loans and business lines of credit are two of the most popular small business financing products available. Below is a side-by-side look at several key differences between these two versatile business financing options. 

Repayment structure

Term loans offer many benefits to small businesses, including the fact that borrowers can often repay the funds they borrow over a longer period of time. Lenders typically require borrowers to make monthly (sometimes bi-weekly) payments with term loans. The longer repayment structure with less frequent payments can be friendly for investments in business growth that take time to provide returns. 

Lines of credit can allow business owners fast access to capital during a time of need. As a tradeoff for speedy and flexible financing, business owners must often repay the money they borrow over a shorter period, compared with other sources of financing. In addition to expedited repayment terms, the payments themselves may also occur on a more frequent basis. Some lenders may require borrowers to make weekly payments toward the money they borrow from their LOC, though others may offer a less demanding payment structure. 

Interest rates and fees.

Term loans often feature lower interest rates than other types of business financing, including lines of credit. At the time of writing, you might find interest rates as low as 8.49% with a business term loan, depending on your creditworthiness and other factors.

In addition to the interest rate a lender charges on your loan, it’s also important to watch for additional fees that could increase your overall financing costs. Such fees might include origination fees, application fees, late fees, and prepayment penalties. If you’re comparing term loans from multiple lenders to search for the best deal available, this free business term loan calculator from Lendio can help you crunch the numbers. 

Lines of credit often feature higher interest rates compared to business term loans and other sources of financing. Interest rates commonly range between 8% and 24% on business LOCs at the time of writing. 

With lines of credit, many lenders also charge annual fees that can increase your total cost of credit. Origination fees, maintenance fees, late fees, and other expenses are also common. So, be sure to read the fine print before you sign any financing agreement. You can also use this free line of credit calculator from Lendio to compare the cost of multiple business LOC options. 

Financing uses

When to consider a business term loan.

If your business needs financing for any of the following reasons, a term loan could potentially be a good fit.

• Opening a new location – Expanding to a new business location requires a sizable upfront investment that might take time to produce a profit. A term loan can help you amortize the investment over several years.

• Hiring new employees – A term loan is a great way to handle the upfront costs associated with bringing on new staff and can provide a cash cushion for your business to manage increased payroll expenses.
• Renovations and capital improvements – A term loan can stretch out upfront renovation costs, enabling your business to continue to run without a sizable cash outlay.

When to consider a business line of credit.

The following situations are examples of when a business line of credit could be helpful to a business. 

• Cash flow management – Many small businesses struggle to bridge the gap between accounts payable and accounts receivable. With a line of credit, a business can use this resource to pay its vendors and repay the funds it borrowed once its customers pay their invoices.

• Seasonal sales cycles – Businesses that have a busy season could use a line of credit to ensure a cash cushion during slower months. 
• Inventory purchases – A business can draw on the line of credit to purchase inventory and pay it down when it sells the inventory at a later date. 

Lender requirements

How to choose the right financing solution for your business.

If your business needs access to capital, but you’re not sure which type of financing makes the most sense, start by answering the following questions. 

• Why does your business need financing?
• Is your business able to satisfy stricter lender borrowing requirements (with regard to credit, revenue, and time in business) or do you need a more lenient approval process?

Based on the answer to these questions, you can begin your search for potential business financing options. For example, if you have great credit, along with sufficient revenue and time in business and you want to borrow money to expand your business, a business term loan might be a solid choice. However, if you have credit problems, your business is relatively new, or you need repeated access to a cash flow financing solution, a line of credit might work better for you. 

Finally, remember that term loans and business lines of credit are not your only two options. Although these are two of the most popular and useful small business funding resources available, there are other types of small business loans you can consider if you feel like your business needs alternative financial resources.