Understanding the Differences Between a Term Loan vs a Line of Credit

For small business owners in Colorado, there are multiple funding options available at hand. However, a line of credit and term loans are two of the most preferred external financing options.

So, if your business is going through a cash crunch, which is the right option?

The type of financial helplines you use to support your entrepreneurial journey plays an important role in determining the business growth trajectory. So, before you choose between the two, it is necessary to have a clear understanding of a term loan vs. a line of credit.

What Is a Term Loan?

A term loan is a one-time lump sum of cash paid to a business under specific borrowing terms. The money is paid upfront, and the business agrees to repay as per a monthly schedule with a fixed or variable interest rate. The interest rate will depend on multiple factors, including the business credit history and cash flow.

Term loans can be used to manage personal and business expenses. For small businesses, a term loan is effective for providing financial stability and managing various operational expenses. The loan can also be used for purchasing equipment and real estate, debt consolidation, managing payroll, funding large projects, and more.

Here are some of the key features of a term loan.

• Term loans can be secured, which means they are backed by collateral like real estate or equipment. However, businesses with solid creditworthiness may not need collateral, and the loans remain unsecured.
• These loans can come in short-term, intermediate-term, and long-term options.
• Since you follow a predictable repayment schedule, budgeting is easier.

What Is a Line of Credit?

By definition, a business line of credit is a flexible financial arrangement that allows you to borrow money up to a preset limit. Just as a credit card comes with a maximum spending limit, you can use a line of credit to access funds when needed, repay it, and borrow again. However, a line of credit has lower interest rates than credit cards and a higher borrowing limit.

For a business, a line of credit can be useful for managing short-term cash crunches. It can also be used to manage unexpected expenses, seasonal fluctuations, and to purchase specific items for the business. 

Think of an expense where the cost cannot be determined upfront. A line of credit can be super handy in such situations. Since a line of credit is flexible, you can use the amount for multiple purposes based on the goals of your business.

Let’s take a look at the key features of a line of credit.

• A line of credit can be unsecured or secured. Some businesses may need collateral to be eligible for it.
• Since you can borrow and repay multiple times within the limit, a line of credit is also called a revolving credit.
• The borrowed amount can be repaid immediately or over a longer period in regular installments. Interest will be charged on the amount you borrow.

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Main Differences Between a Term Loan vs Line of Credit

While both of these are credit facilities provided by financial institutions, there are major differences between the two.

• A term loan involves a one-time payment, and it is a non-revolving option. A line of credit is a revolving loan where the amount borrowed is repaid and borrowed again. This means there are no limits on the number of times the fund can be accessed in a given period. 
• While a term loan offers you a fixed amount of cash, a credit limit for a line of credit can be increased or decreased based on your spending and repayment patterns.
• For loans, interest accrual starts from the point the lump sum amount is disbursed into your business account. In case of a line of credit, interest is calculated not on the credit limit, but only on the outstanding amount.
• Loans have a fixed tenure and are paid back in predetermined monthly installments over this period. On lines of credit, you can pay back a part or all of the outstanding amount. One thing is, you need to pay back the minimum amount mentioned in the monthly statement. Failing to pay that amount will attract higher interest rates.
• Typically, a term loan is used for larger business expenses or for purchasing high-value items. In contrast, a line of credit is typically used to meet smaller expenses and short-term requirements.

Both loans and lines of credit have their distinct advantages and disadvantages. Time to take a closer look at them.

Pros and cons of term loans

Pros

Generally, term loans are sanctioned to businesses with a solid financial record. Hence, the loan amounts are generous. Since they have relatively lower interest rates, term loans can help you save more over the life of the loan. Besides, receiving a sizable fund allows you to effectively manage long-term projects and growth initiatives. 

A clear and predictable repayment plan allows businesses to plan their finances and avoid cash flow gaps. Since long-term repayment options are available, you can spread out the repayment over a long period. Plus, by making regular and timely payments for term loans, you can increase your credit score.

Cons

Remember, having a business license in Colorado does not make you eligible for a loan. Most traditional banks have stringent eligibility guidelines for term loans, like high credit scores and a sizable business revenue. Generally, a term loan is more suitable for a business that has been operating profitably for two or more years. Another barrier for some businesses is the requirement for collateral. 

Since an extensive amount of paperwork is needed during the loan application, the time for loan approval is also on the longer side. Failure to pay back the loan will damage your credit scores and can result in the loss of collateral. Moreover, long-term loan obligations can limit your chances of qualifying for a future loan.

Pros and cons of lines of credit

Pros

A big advantage of a business line of credit is its flexibility. You can withdraw funds at a relatively low interest rate and use them for managing any unforeseen business expenses. The interest is payable only on the borrowed amount, which is a part of the credit limit. This results in lower monthly payments and a manageable financial stretch.

Compared to traditional term loans, there is no lengthy approval process, giving you quicker access to the funds. This makes a business line of credit great for managing sudden cash-flow gaps and time-sensitive opportunities.

Cons

The flexibility and ease of use of a line of credit can be a double-edged sword, as it can lead to overuse. Excessive withdrawals can strain your finances and make repayments difficult. In the end, this can cause debt accumulation and damage your creditworthiness.

When it comes to low-interest lending for small businesses, a line of credit is not always the best option. The variable interest rates associated with it can introduce uncertainty and affect your cash flow. In addition, some lenders may charge annual or monthly fees for maintaining a line of credit, even if it is left unused. 

How to Choose the Right Option for Your Business

When deciding between a line of credit vs a term loan, the most important thing to consider is how you plan to use the funds. Generally, for one-time investments – like acquiring real estate, long-term assets, or equipment – a term loan is a better option. This is due to the relatively low interest rates and organized repayment. Besides, you can keep any balance amount from the loan as working capital.

Nevertheless, you need to balance the repayment period with the life of the goods you buy. Consider that a new piece of equipment will last for six years. The loan taken for funding should have a similar repayment period.

A line of credit works great for managing temporary cash flow fluctuations, especially during lean periods. For example, you may need to make a payment to the suppliers within 30 days. But the payment from customers will not come in for 45 days. A line of credit makes great sense in this case.

In short, we do not recommend using a line of credit for one-time high-value purchases, business expansion, or refinancing debts. Likewise, do not use a term loan for managing short-term business expenses. Such mistakes can create needless financial strains on the business.

Term Loan vs Line of Credit: FAQs

Can a loan be used like a credit card?

Generally, a loan cannot be used as a credit card. Unlike business loans, a credit card is mostly used to manage everyday spending and for reward programs. A line of credit offers a revolving credit similar to credit cards, but the interest rates are lower. Besides, you get more than a month to repay the amount.

Are there disadvantages to opening a line of credit?

Even though it is a flexible option, opening a business line of credit has some disadvantages. It can come with multiple loan fees, and the variable interest rate can be on the higher side. Moreover, frequent withdrawals from a line of credit can draw you into a cycle of debt.

Why might a loan be better than opening a line of credit?

If you have a one-time fund requirement for a specific purpose, a loan can be a better option than a line of credit.

Is it harder to get a loan or a line of credit?

That depends on your business revenues and credit scores. If you do not have strong credit, qualifying for a line of credit can be harder than a term loan.

Final Thoughts

Taking a loan can be a big step for a small business in Colorado. Knowing the difference between a line of credit and a loan makes it easier to choose a financial tool that works for you. Use the cost of debt formula to ensure that taking a loan makes sense for the business. Once you have taken a loan, try to develop a cash flow projection to foresee any gaps and avoid disruptions in the repayment process.