So your business needs financing. Once you’ve created a funding plan that shows how much money you’ll need to borrow, when you need to receive it, and when you hope to have it repaid, you’ll be ready to survey your loan options. One of the first decisions you’ll often face involves weighing the benefits of a line of credit vs. loan options.
There are no silver bullets in the financing world, so it’s impossible for someone to conclusively state that there’s a universal winner in the line of credit vs. loan debate. What matters is that you carefully review the pros and cons of both types of financing, then select the option that lines up with your small business goals.
In general, a line of credit is simpler to acquire and use because it shares so much DNA with the credit cards most people already have in their wallets. Basically, if you know how to use a credit card, you know how to use a business line of credit.
Depending on your unique situation, you can qualify for up to $500,000. The interest rates start in the neighborhood of 8%, and your repayment terms will have a maturity of 1–2 years.
Given the flexibility of a business line of credit, you can use it as a “stimulus plan” for your business. If sales are consistent and you have the capital you need, there’s no need to use the line of credit. But if you were to find yourself in a bind, it’s reassuring to know that you already have a safety net available.
“Entrepreneurs frequently encounter difficulties managing their cash flow as a result of seasonal credit demands and time gaps between capital needs and revenue realization,” explains a line of credit guide from The Balance. “This is especially true of business startups during their early stages of development when they have not diversified enough to generate a constant positive cash flow. Once inventory has been purchased, it is necessary to ride out the cycle until accounts receivable have been collected.”
Each time a billing cycle comes around, you can choose to make a partial payment or take care of the entire balance. If you don’t pay in full, the remaining balance will carry over to the next cycle. Be aware that interest will accrue on this amount, which is an incentive to pay your bill as promptly as possible.
Qualifying for a business line of credit isn’t difficult as long as your company has been operating for 6 months and makes at least $50,000 a year. Lenders tend to be more lenient with this form of financing, so even if your credit score is as low as 560, you could be a candidate.
Most business lines of credit are secured, meaning the lender asks you to identify a personal asset that could be used as collateral if you were to default. Common examples include real estate, homes, vehicles, and bank accounts. In rare situations, the lender may view you as a low-risk borrower and allow you to proceed with an unsecured line of credit that won’t put your personal assets in jeopardy.
There are obviously many more types of different business loans than there are lines of credit. For example, as you refine your search, you’ll want to carefully consider the specifics of an SBA loan vs. line of credit or a fixed term loan vs. line of credit. In general, you can qualify for anywhere from $1,000 to $5,000,000 with a business loan. Interest rates may vary from 4% to 25%, with the repayment terms starting at 1 year and going up to 25 years.
Even if the interest rate associated with a specific business loan is higher than what you’d find with a business line of credit, the silver lining is that it’s a fixed rate. A line of credit has variable rates, meaning that if you make late payments or accidentally exceed the credit limit, you will likely be penalized with a higher rate.
While business lines of credit give you an ongoing pool of money to dip into, a business loan presents you with a one-time lump sum. You will owe interest on the full amount of money from a business loan, while you only pay interest on the money you use with a business line of credit.
Given the lump sum structure of a business loan, you’ll need to make consistent payments. Whether it’s set up monthly or every 2 weeks, you can’t take a vacation from your payments until you’ve paid off your balance. With a business line of credit, on the other hand, you only need to pay for the funds you’ve used. If you don’t use the line of credit for 3 months, you won’t need to make a payment during those 3 months.
Because business loans have fixed rates, longer repayment terms, and higher dollar amounts, they’re better for long-term financing. But they can be more rigid and slow-moving, so when short-term needs arise, such as repairs, financing receivables, marketing, adding inventory, or handling payroll, a line of credit can be ideal for providing the money you need in a hurry.
The only way to identify the best financing route is to do your due diligence. Every hour you put into preparation can save you entire days of frustration on the back end. So create a plan, review your options, read between the lines, and most importantly, give yourself the time necessary to make an educated decision.