Business Loan vs Line of Credit
Why type of credit is right for your business?
Determining whether to choose a business loan or line of credit should be based on how much funding you need, when you need it, how long you need it and when you can pay it back.
The main difference between a loan and a line of credit is a loan is a lump sum of money issued at one time allowing you to make a specific purchase; a line of credit is like having cash on tap up to the credit limit issued whenever you need it.
Before you decide which funding vehicle to pursue, let’s review both options so you can gain greater insight between the two as well as the pros and cons of each.
A business term loan is the most common type of business loan provided by both traditional banks and non-traditional lenders. Business loans can be used for all types of business needs such as purchasing equipment or inventory, working capital, paying back outstanding company debts, or any other business necessity.
While you can get a business loan from several sources such as banks, credit unions and online lenders, it’s important to note that the application process is rigorous and time intensive.
Secured or Unsecured – A business loan can be secured by putting up collateral such as accounts receivable, equipment, inventory, and real estate. When a loan is secured by collateral the interest rate is generally lower since it is less risky for a lender than an unsecured loan. In addition to supplying collateral, lenders will require a credit check and financials as another measure of assessing risk.
With an unsecured business loan you are not pledging any collateral. Since a lender is taking on greater risk these types of loans are charged higher interest rates compared to a secured business loan. It’s also important to note that qualifying would require impeccable credit ratings. However, one exception is the revenue based loan which is based on your company’s bank deposits not credit scores.
Set monthly payment – The repayment period is fixed on a loan so the monthly payment is usually higher compared to a line of credit. Once you receive a loan the repayment period starts immediately and does not change regardless if you used the funds or not.
Lump sum of money at one time – A business loan is funding that you receive at one time for one specific purpose; it does not renew at the end of its terms. So once you use the funds and need to obtain additional funding you will need to re-apply for another loan and go through the entire application process again.
Line of Credit
A line of credit is a flexible financial tool, in that it can be used to make different kinds of purchases. There are traditional lines of credit and non-traditional lines of credit with each serving a unique purpose. Traditional bank lines of credit are ideal for major big-ticket items such as a vehicle purchase or buying a commercial property. A non-traditional line of credit, like a business credit card, generally is for small purchases such as office supplies, travel expenses or equipment.
Secured or Unsecured – A line of credit can be secured with a variety of collateral options such as real estate, inventory or account receivables. Typically, a traditional line of credit issued by a bank will require collateral and documentation such as financials, personal & business tax returns, and credit checks. However, non-traditional lines of credit such as business credit cards are unsecured requiring only a credit check for evaluation and approval.
Revolving – With a line of credit you have the ability to access funds on an as-needed basis up to your credit limit issued. When you pay down any balance owed, you’ll replenish your available credit making it an essential financial tool for business owners.
No set monthly payment – There is no set monthly payment with a revolving line of credit, but interest accumulates and is taken advantage of like any other form of credit. Once you draw on your credit line you will have a minimum monthly payment requirement.
Lower Interest Rate – The interest rates vary depending on whether the line of credit is secured or unsecured. Since a line of credit that is secured poses less risk to a lender the rate may be lower such as 10%. With an unsecured line of credit the annual APR may be 12-15% since it is more risky for the lender. However, many business credit cards provide a 0% introductory APR period ranging from 6-12 months.
On a final note, it’s essential to plan ahead how the funding you get with a loan or line of credit will be used. While there are many business financing options available, the decision becomes easier when you know what the capital will be used for and for how long.
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About the author
Marco Carbajo is a business credit expert, author, speaker, and founder of the Business Credit Insiders Circle. He is a business credit blogger for Dun and Bradstreet Credibility Corp, the SBA.gov Community, Business.com, About.com and All Business.com. His articles and blog; Business Credit Blogger.com, have been featured in ‘Fox Small Business’,’American Express Small Business’, ‘Business Week’, ‘The Washington Post’, ‘The New York Times’, ‘The San Francisco Tribune’,‘Alltop’, and ‘Entrepreneur Connect’.