When you’re building your business, there may be times when you need money beyond what you have in cash reserves. A line of credit or a loan are two ways to borrow.
A business loan gives you a large, single lump of money which you pay off over time. A line of credit is a flexible borrowing tool. The lender approves how much you can borrow, say up to $50,000. You can borrow, pay off the debt, and then borrow again.
A business loan could make sense if you need money for a specific, major project like buying equipment or renovating your storefront. A line of credit can help balance out swings in your cash flow for working capital.
If you’re trying to decide between a line of credit or a loan, here’s how to help compare.
Key Differences Between Lines of Credit and Loans
A business loan has a set repayment timeline. For example, you might borrow $100,000 and agree to pay it back over five years. Fixed loans can be for larger amounts of money than a line of credit, depending on your creditworthiness and revenue.
Business loans charge interest on your outstanding loan balance. When you apply, the loan will show how much interest you owe throughout the repayment schedule. Business loans may set restrictions on how you can use the money. If you apply for a loan to buy equipment, a lender might not allow you to change your mind and then use the funds to cover payroll.
Flexibility is a key difference between a loan and line of credit. A line of credit lets you borrow when you want and pay the money back at your convenience. It operates like a credit card but with a lower interest rate. You only owe interest while you’re borrowing against the line of credit. The lender might charge ongoing fees for an unused line of credit but not interest. You can usually use the line of credit funds however you want.
|
Business Loan |
Line of Credit |
Available Financing |
Depends on the lender, but higher possible limits than a line of credit |
Depends on the lender, but usually lower than a loan |
Repayment Schedule |
Fixed payments over a set schedule |
Minimum monthly payments but otherwise at your convenience |
Interest Rate |
Varies, but usually lower than a line of credit |
Varies, usually higher than a loan but lower than a credit card |
Collateral |
Usually required to secure the loan |
Not always, but may require a personal guarantee instead |
Qualifying |
Requires higher revenue, a better credit score, and more years in business |
Easier requirements than a loan |
Advantages and Disadvantages
Business Loan Advantages
- Can provide more money than a line of credit
- Lower interest rates than lines of credit
- Longer repayment terms, up to 25 years
Business Loan Disadvantages
- Only provides money once
- May require you to use the money for a specific purpose
- Could require collateral to back up the loan, like inventory or equipment
Line of Credit Advantages
- Flexible and can be used for any business expense
- Option to borrow, repay, and borrow again
- Might not require you to put up any collateral
Line of Credit Disadvantages
- Lower borrowing limits than business loans
- Higher interest rates than a business loan
- May charge annual fees or inactivity fees
Understanding Application Timelines
Business loans and lines of credit can typically follow similar application timelines. It depends on where you apply. If you work with a traditional bank or credit union, you can expect the application process to take several weeks. If you apply for a Small Business Administration (SBA) loan, the process can take up to 90 days.
Flexibility is a key difference between a loan and line of credit.
Traditional lenders need time to process the application for these loans and lines of credit. It’s longer than applying for a credit card.
If you need money quickly, you might consider online small business lenders. They process applications and can pay out loans and lines of credit within days. In exchange, they typically charge higher interest rates than traditional lenders, making borrowing more expensive.
Factors Considered by Lenders
When you apply for either a business line of credit for a startup or a loan, lenders will consider similar factors:
- Your personal and business credit scores
- The purpose if it’s for a loan
- The amount you’re trying to borrow. Qualifying for smaller loans is usually easier, but the amount must make sense. If you say the loan is to pay for a significant renovation, but it’s for a small amount, the lender could become suspicious.
- How long you’ve been in business. A loan or line of credit may require a minimum like having been in business for at least two years.
- Your past revenue
- Your other assets to secure the loan, including cash, equipment, vehicles, and real estate
- Your business plan
It can be easier to qualify for a line of credit because they're for less money. For example, a lender may require annual revenue of $300,000, a 680 credit score, and collateral for a business loan, but give a line of credit if you have $100,000 in annual revenue, a 620 credit score, and no collateral.
The lender may require you to put up a personal guarantee for the line of credit, meaning you’d need to pay the money even if your business fails. Personal guarantees are possible for business loans but less likely, especially if you put up other collateral.
Risk Management and Financial Security
Business loans and lines of credit can be valuable tools if used properly, consider following proper risk management practices:
Maintain cash reserves for payments: You'll make monthly payments for your loan and line of credit. If a surprise slowdown means you’re short on cash and miss a payment, the lender could charge penalties, increase your interest rate, and report the missed payment to the credit rating agencies, hurting your credit score. You can keep proper emergency cash reserves to cover the loan and other liabilities.
Borrow before you need the money: Since applying for a loan or line of credit takes time, you can secure them well before you’re in a cash crunch. This makes the most sense with a line of credit since you don’t have to borrow against it until you need the money.
Understand the credit score impact: An open line of credit does not hurt your credit score. It’s like having an open credit card balance. Keeping a line of credit open for longer builds up your history, and making the payments on time can help your score. On the other hand, maxing out your line of credit and not paying it off can hurt your score.
Diversify your funding sources: Consider financing through multiple lenders rather than just one. If one lender fails or changes its mind and cancels your business line of credit for a startup, you can still have access to capital elsewhere.
Only borrow what you can pay off: Borrowed money is another liability your business needs to pay off. You can forecast how the money will improve your cash flow and revenue and, more importantly, how you will repay it.
Industry Trends and Predictions
As you prepare to apply for business financing, it can help to know the latest market trends.
High-interest rates, with future relief possible: While U.S. rates remain steady, Mexico and Switzerland reduced theirs last week, according to an Investopedia article. Meanwhile, U.S. Federal Reserve officials said they're waiting to gain confidence that inflation will reach its annual goal of 2% before making any cuts, the article notes.
Going digital: Traditional brick-and-mortar lenders are increasingly adopting technology, helping make it easier to apply for financing and quicker to get approved. Additionally, the Small Business Administration (SBA) recently launched an upgraded matching tool to help small business owners find and compare funding options, including from banks and private lenders.
Where to Get Business Loans or Lines of Credit
Traditional banks and credit unions offer business lines of credit and loans. Given that lending standards are tighter, it could help to work with the bank where you already have a relationship, like the one that runs your business checking account or credit card. That history could make a difference for your application.
You could try applying with the lender using an SBA loan. The SBA helps businesses qualify for loans and lines of credit by partially guaranteeing repayment if the business owner defaults. You help your chances of qualifying, though the SBA adds an extra fee to your loan cost.
Online small business lenders are another option. Online lenders usually are more likely to approve loans and lines of credit but charge higher rates than banks and credit unions.
You might consider applying with multiple lenders for your loan and line of credit. That way, you have more chances to qualify and see who comes up with the best offer.
As part of your research toward funding your business, you can consider how much money you need for your line of credit or loan. You can look at your past results, including cash flow swings. How much money would it take to manage those past shortfalls properly? Based on your future cost and revenue projections, how much do you think you’ll need? This review can help you prepare a more effective loan application and take advantage of money once it comes in.
The Takeaway
It can be worth considering if a loan or line of credit is best for you based on your business needs.
Photo: Getty Images
