When you need to borrow money to start or expand your business, or if you just need to get a loan for other purposes, you have several options. Two of the most common options for acquiring funding are term loans and lines of credit. It is important to know the difference between the two, as well as their pros and cons, so that you can make an informed decision and choose the best option for your needs.
What is a term loan?
A term loan is a lump-sum extension of funds that you pay back in installments on a regularly defined schedule (or "term"), plus interest. When utilized for a small business, they are also commonly referred to as small business loans. However, term loans might also be used for a mortgage, auto loan, student loans and other situations in which you might need to borrow a large sum of cash.
What is a line of credit?
A line of credit is an offer to extend funds to an individual or business that can be drawn down at a later date. For instance, a business with a $50,000 line of credit can borrow up to that much, but does not have to take all of it. Lines of credit for small businesses are somewhat similar to a credit card, except that they typically have a much higher limit and can be taken in cash rather than at a point of sale.
Differences between term loans and lines of credit
Aside from what was defined above, other differences exist between the two borrowing options that you might want to consider before you make a choice.
- Standard term loans or small business loans give you one lump payment which you repay over a predefined term; funds related to lines of credit are typically "revolving" (they can be borrowed over and over so long as you keep paying it back).
- Term loans usually grant much larger amounts than lines of credit.
- Term loans are usually secured against assets or collateral.
- The funds for a term loans are transferred to the borrower at the time of contract; lines of credit give you the ability to start borrowing right away, but you aren't required to borrow anything until you need to.
Pros and cons of term loans
- You have access to the funds immediately.
- Term loans usually grant very high amounts.
- Interest rates tend to be lower than a comparable line of credit.
- The approval process can be tedious and lengthy.
- Interest begins accruing immediately.
- You typically need a specific purpose for the loan.
- Closing costs can be high.
Pros and cons of lines of credit
- Lines of credit are easier to get.
- They are a more flexible option, ideal for emergency funds or working capital.
- You don't begin accruing interest until you use the credit to make a purchase.
- Repayment terms are shorter.
- Interest rates tend to higher than a comparable term loan.
- They typically come with terms and conditions for continued access and can be easily revoked if you fail to comply.
- They can typically be "pulled" by the lender at any time for any reason (e.g., if the lender has liquidity problems).
- Lines of credit provide smaller amounts than term loans.
Weighing Your Options
So should you get a line of credit or a term loan?
Our typical recommendation is to get both.
Get a line of credit for day-to-day working capital and cash flow needs (ideally from a bank or a low-cost alternative lender like DealStruck). And then get a term loan for larger projects or more significant working capital needs.
See how much you can qualify for without affecting your credit score.