Knowing how to evaluate the types of financing available to your business can be difficult. So when do you need a loan vs. a line of credit?
A loan is pretty easy to understand, though the paperwork and legal boilerplate can often be overwhelming. A lender gives the borrower money to be repaid over a period of months, quarters or years. In exchange for the loan, the borrower pays interest on monies received. The lender puts its money to work earning interest paid by the borrower.
A line of credit is a type of loan that can provide a number of benefits to borrowers.
Here's how a line of credit works.
A lender approves your company for a $50,000 line of credit. That means your company can borrow and owe up to $50,000 at any one time – but isn't required to borrow the full amount. With a straight, term loan you receive the entire $50,000 up front and pay interest on the full amount starting on day one.
With a line of credit, your business has flexibility to choose when and how much to borrow. For instance, your company may decide to draw only $5,000 on its $50,000 credit line. In this case, your monthly payment and interest charge is based on the $5,000 actually borrowed, not on the entire $50,000 credit limit, saving you a lot on interest payments.
In subsequent months, if you draw more from the credit line, your payments increase along with interest charges. You can pay back and "re-borrow" from a credit line so you have a cash cushion when your business needs it.
In the case of a loan, funds are disbursed up front and interest on the entire loan amount is due periodically whether your business uses the capital or not. A credit line is used when funds are needed and for whatever reasons company management deems appropriate for business growth.
Which type of credit is right for your company? Let's take a closer look.
- Term loans give your company the full loan amount up front. The money is then repaid in prearranged monthly installments throughout the term of the loan. The term of a commercial loan typically ranges from one to 15 years.
Interest is charged on the outstanding balance of the loan, and the interest rate charge is and the interest rate charge can be fixed or variable. Term loans make sense when a company needs funds for a specific purpose: an equipment purchase, capital improvements, facilities expansion, marketing and other business expenses.
- Lines of credit give your company the option of borrowing as much money as you need, when you need it, up to a pre-arranged maximum amount that can be outstanding at any one time.
Interest is charged on the outstanding balance, not on the unused portion of the line of credit. Interest rates are almost always variable and are tied to a standard index like the prime rate.
How does your business qualify for a line of credit?
A good business credit rating and a solid, company financial history are required. Few lenders will approve lines of credit for start-ups or businesses without a track record of financial success.
Be prepared to provide financial documentation like profit and loss statements, balance sheets and company tax returns when applying for a credit line.
Many lenders also require other collateral to secure a line of credit. A business line of credit is almost always asset-based, with hard assets, like equipment or facilities, used as collateral to back the credit line. Credit lines can also be secured by receivables and even inventory – though inventory securitization is less likely because the value of inventory can decrease rapidly, especially with seasonal or cyclical businesses.
Deciding whether to choose a line of credit or a term loan should be based on how much capital you need, how long you need it and when you can pay it back.
Talk to a commercial loan officer with your bank to determine whether a credit line or a term loan is better for your business.