Line Of Credit Versus Business Loan – Pros And Cons
As a normal course of business activity, an owner most likely will need to consider a line of credit versus business loan as the preferred financing option for additional working capital. This may be due to an unplanned need to purchase equipment and inventory, a special investment opportunity or unexpected cash flow issues due to account receivables delays. For a multitude of legitimate reasons, you will need to consider both options as a means to raise needed capital.
A business loan is simply a debt a business assumes in order to meet the financial needs in a business. A line of credit is a financial agreement between a business and lender that establish a maximum loan amount that your business can access and maintain. While there similarities between the two financial options, there are differences that you should be aware of before reaching a decision.
Here are the pros and cons of a line of credit versus business loan for your business financial needs:
Business Line Of Credit
A business line of credit gives your business access to a certain amount of capital that they can repeatedly used as needed, with few limitations on use. Once your business has paid back any credit line draws (tranches) in full, the credit line resets to the original amount. Your business doesn’t have to use the entire amount of credit that the lender extends and only has to pay interest on what they actually use. This is referred to as a revolving line of credit and is an excellent multipurpose business tool for unpredictable, cyclical, and emergency financing. (A non-revolving business line of credit does NOT reset your credit line to the original amount, hence there is a total limit to your credit use.
A business line of credit carries a monthly minimum and variable repayment schedule on the amount that you draw on the line of credit. The lender will also normally include “draw fees” or establish minimum draw amounts each time the line of credit is accessed. If your business does not draw on the credit line in a given month, there are normally no charges by the lender. There may be an lender annual renewal fee to maintain the business line of credit open.
As an example, if your business has a line of credit of $100,000 and you take a draw of $3,000 (10% of the total), and wish to payoff the draw on your credit limit in 12 months, you can expect:
- Tranche draw fee of $50, paid apart from your line of credit
- Line of credit draw amount of $3,000
- Amount balance accruing interest, $3,000
- Interest rate of Prime Rate + 3% (8%)
- Results in monthly payment of $261
- Normally there are no penalties to payoff the draw balance early
A business line of credit is similar to a business credit card in that both are a form of revolving credit. Where they are different is that the business line of credit has higher credit limits, lower interest rates, more stringent lender guidelines and the flexibility to convert to cash without additional fees.
Financial lenders offer both secured and unsecured business lines of credit. Normally to qualify a business needs to be established, with a minimum of two years in operations, profitable, a history of growth and strong cash flow, plus strong business and owner credit history.
Pros: Flexibility in use | revolving payment cycle | less expensive than business credit card
Cons: Smaller loan amounts than business loan | extensive paperwork | long evaluation process | restrictions to qualify
For a secured small business term loan (less expensive than unsecured), a traditional lender requires that your business has a minimum of two years in operation, be profitable, has good business and owner credit history, plus a business asset (e.g., property) to serve as collateral guarantee. The loan evaluation process will be time consuming, require detailed bank statements, multi-year financial reports, future sales projections, business asset market evaluation and business and personal credit reports.
This type of financing offers a business the lowest interest rate (cost) for capital and length of payment terms. Unlike a business line of credit, your business loan will provide a lump sum of capital that will be designated for a specific business use, based on the terms of the lender agreement. Since the amount borrowed is secured by collateral and with a specific use, the amount borrowed can be significantly higher than a business line of credit. Normally this will for buying equipment, inventory, property, etc. This limitation in use forces financial prudence and stability for the business. However it does not allow for flexibility if there are issues related to cash flow, rather only late payment fees and damage to the business financial history.
A business loan will have a fixed repayment structure that will normally require regular monthly payments. While the interest rate will be less than a business line of credit, you will be paying interest on the entire balance of the loan, rather than just the credit draw. Additionally, if you choose to pay off the balance of the loan prior to its term, there is usually an early payment penalty fee and the need to payoff the remaining interest on the loan, resulting in a higher effective interest rate. A business loan also includes a lender origination fee, unlike a business line of credit.
Pros: Lowest interest rate | long fixed rate terms | forces financial prudence | easier to qualify.
Cons: Restricted use | limited payment flexibility | extensive paperwork | long evaluation process.
Line Of Credit Versus Business Loan – Conclusion
An owner should consider the options of a line of credit versus business loan for the financial needs of business’ growth and acquisitions. A secured business term loan offers the lowest interest rate and length of payment terms if a specific investment purchase is needed. A business revolving line of credit offers greater flexibility in use of the capital, but with a higher interest rate and lower limit on total capital funded. Each financial solution, or combination, may fit your business depending upon your specific needs.
Please call us at (888) 213-3383 to help review which financial product best serves your business needs or Contact Us via Email.