Business loan vs. line of credit
If you’re someone with bold visions of opening your own business or expanding your existing business, you’re probably already thinking about the best way to finance such a project. While there are a lot of options out there for additional streams of cash, like grants or crowdfunding, the two that typically pop up at this stage are business loans and business lines of credit. There are advantages and disadvantages to each avenue. Let’s look at the key differences between a business loan vs. a line of credit, see how they might benefit your business, and determine which, if either, is the right one for you and your business.
What is a small business loan?
So, what exactly is a small business loan? Essentially, they’re lump sums of cash provided by lenders to small businesses that are paid back with interest over time. Depending on your needs or goals, there are many loans available for small businesses ranging from small, short-term loans that are to be paid back in a term of six months to one year all the way up to larger long-term loans with term limits that typically exceed three years.1
Small business loans can come from a multitude of sources. One of the most common places to start is the Small Business Administration, or SBA. This government agency partners with vetted lenders, community development organizations, and micro-lending institutions to bring together small business owners and funding. The organization is also in charge of setting the guidelines and rules of repayment for all lending parties involved.2, 3 However, they’re not the only source for such loans. Depending on the type of financing you need, loans can come from banks of all sizes, non-profits, or even community groups.
Types of business loans
- Term Loans – Term loans, such as long-term business loans, are one of the more common forms of lending, with a bank or some other lender providing funds that will be repaid over a fixed time period.
- Startup loans – If your business hasn’t gotten off the ground yet, a startup loan may help. These loans can be easy to procure, with minimal credit or business requirements.
- SBA loans – If you already have a solid credit score, your business may qualify for a loan guaranteed by the Small Business Administration. This means that if you were to default on the loan, the SBA would pay up to 85 percent of the cost. SBA loans are typically considered safe for lenders and may provide a more affordable option for your business.
- Personal loans – Sometimes it’s more feasible to get a personal loan and use it for business expenses rather than getting an actual business loan. The payouts from these loans are usually lower, and approval will depend on the leniency of the lender, but they may provide a convenient way to rebalance your books in the short run.5
What is a business line of credit?
A small business line of credit is similar to a credit card in that the lender agrees that you are permitted to borrow a certain amount of money. That limit cannot be exceeded; however, like a credit card, you only pay interest on the money you borrowed, and as you pay it down, you can continue to spend up to your limit repeatedly without issue. This makes access to cash fast and flexible, allowing for continued spending through an extended, ongoing period of growth or expansion.6
Types of business lines of credit
- Securities-backed line of credit – This line of credit is backed by securities belonging to the borrower, allowing them to access additional funds worth 50 to 95 percent of the securities’ value.
- Personal line of credit – If your personal finances are in better shape than your business, a personal line of credit may be the way to go. You’ll need a healthy credit score and no history of defaults, but once you’ve been approved, you can borrow and repay as often as your business needs.
- Business line of credit – You can access more flexible financial support via a business line of credit, which is extended by the lender as necessary rather than settling on a fixed loan. When considering a business line of credit vs. a loan, consider whether your business will need additional funds down the road.
- Home equity line of credit – If you’re looking to personally finance your business, you can look to your home for a source of funding. A home equity line of credit generally provides financial support equal to the market value of your home minus the amount you still owe on your mortgage. This arrangement allows you to access these funds repeatedly over the draw time of the line of credit, provided you’ve been regularly paying it off. You won’t get the same flexibility from your mortgage vs a line of credit.7
Deciding between a business loan vs line of credit
| Definition | Pros | Cons | |
|---|---|---|---|
| Business Loan | Borrower receives funds one time, then pays off principal and interest until repayment is complete. | Lower interest rates
Often provide more funds than line of credit |
Interest begins to build as soon as terms are agreed upon, whether the funds have been used or not.
One-time payment offers less flexibility |
| Line of Credit | Borrower can continually make use of credit line while simultaneously paying off principal and interest. | Interest does not begin accumulating until funds are used.
Flexibility of repeated access to credit funds. |
Interest rates are often lower for a loan vs line of credit interest rates, which may be higher
May provide fewer funds than a loan |
So how does one decide between a loan or a business line of credit? There are a few factors that come into play when figuring out what will best fit the bill. Some questions you may want to begin asking might be:
- How large of a loan will you need?
- How long will you need to repay the borrowed funds?
- What will you be using the funding for?
Additionally, make sure to familiarize yourself with some of the criteria that lenders may be reviewing such as your:
- Credit score
- Businesses cash flow
- Business plan and how it relates to when and how the loan will be spent
- Debt to income ratio. 4, 9
The most common type of short-term small business loan is commonly referred to as a working capital loan. This type of loan is usually lent for short durations of time and in small amounts. It’s for everything from paying rent during slower periods of business to paying down higher-interest debt. Depending on the lender, sometimes these loans are directly linked to personal credit and can affect your credit score if payments are not made regularly on time.1, 4, 6
The cycle of borrowing and repaying on a small business line of credit is extraordinarily helpful for longer term projects. For example, to expand a facility or introduce a new product line where unexpected delays or expenses may occur it’s nice to have the flexibility to continue using up to your spending limit and paying it down time and time again.4
There are other types of business loans too. For example, if you’re looking for a larger loan with a longer repayment runway, a good place to start would be looking at small business term loans. These are generally a single large, lump sum loan for things like facility expansion, a lengthy research and development project, or any other large single expense. For the most part, these loans are paid back over the course of three to five or more years and can have both fixed or variable interest rates depending on the lender and factors such as your credit score, cash flow, debt-to-income ratio, and others.1, 4, 6
Deciding between a business loan or a line of credit is contingent upon the needs of your business. Review your goals and comfort level prior to borrowing.
Which type of credit is right for your company?
Before reaching out for a line of credit or loan, it’s important to start with a thorough assessment of needs. A detailed business plan with clearly defined short and long term goals is important in making a final decision. There are a lot of options out there for small business owners. You’ll have your pick between large commercial banks, small local banks, SBA-backed loans, and more. There are plenty of options available for either route you choose. Remember to know the requirements as well as advantages and disadvantages of each avenue before applying.
No matter which option you ultimately chose, remember that paying your loans on time is vital to building and maintaining a healthy credit score as well as developing a good rapport with banks and lenders with whom you may do business again in the future. If you’re looking for more small business resources, the Business Solutions Center is a great place to start.
[1] “Business Loan or Business Line of Credit: Which Is Best for You?,” experian.com/blogs/ask-experian/business-loan-vs-business-line-of-credit-whats-the-difference/ (Accessed March 2024)
[2] ”Small Business Administration,” sba.gov (Accessed March 2024)
[3] Welcome to Benefits.gov,” benefits.gov/benefit/1497 (Accessed March 2024
[4]”The Best Small Business Financing Options in 2020 Compared,” nav.com/business-financing-options/ (Accessed March 2024)
[5] “13 Types of Business Loans: Find The Best Loan,” forbes.com/advisor/business-loans/types-of-business-loans/ (Accessed April 2024)
[6]“Best Small Business Loans,” forbes.com/advisor/business-loans/best-small-business-loans/ (Accessed March 2024)
[7] “Line of Credit (LOC) Definition, Types, and Examples,” investopedia.com/terms/l/lineofcredit.asp (Accessed April 2024)
[8] “Loan vs. Line of Credit: What's the Difference?,” investopedia.com/ask/answers/110614/what-difference-between-loan-and-line-credit.asp (Accessed April 2024)
[9] ”Small Business Loan Requirements” www.business.org/finance/loans/business-loan-requirements/ (Accessed March 2024)