Line of credit vs. loan: Which is right for you?
Your business is poised for growth. All that’s missing? The money to make it happen.
If you’ve used a credit card — or even an IOU — then you’re already familiar with the concept of borrowing money. A business line of credit and a term loan are two ways that you can borrow the money you need to reach your business goals.
There’s no “right” way to borrow
Both a business line of credit and a term loan let you borrow large amounts of money, typically more than you can on a credit card. Each method has its advantages. Making the best choice will come down to your business’s unique circumstances.
Read on to discover the key differences between a business line of credit and a term loan so you can better determine which is a better fit for you.
What is a business line of credit?
Picture a water tank that’s full and ready to use. When you need water, you turn a tap and it flows out. Once you have enough, you turn it off.
A business line of credit is similar: It allows you to borrow money up to a set limit, but you can control when and how much you use.
Using a business line of credit, you can access flexible, on-demand cash and only pay interest on the amount you use. It’s a good option for funding short-term expenses that you can’t put on a credit card, like payroll and covering fluctuations in cash flow.
What is a term loan?
If a business line of credit is like a water tank with a tap, a term loan is like a swimming pool. All at once, you have a significant sum of money to fund large purchases or long-term investments.
A term loan generally contains two parts: the principal, or total amount borrowed, and the interest. Interest is charged as a percentage of the principal and is included in the loan’s terms and conditions. Because term loans can give you a lump sum of upfront cash, they’re often a popular choice for specific one-time purchases.
4 key differences between a line of credit and a loan
Although a business line of credit and a term loan are both ways for your business to fund large purchases, there are important differences between the two. It’s like comparing apples and oranges — they’re both fruit, but they’re definitely not the same.
1. Repayment schedule
Payments for a business line of credit are due regularly and are determined by how much you spend. Every payment period, you’ll get a bill for the amount borrowed in addition to any interest charges, much like a credit card bill. Your lender might ask you to pay your balance down to zero annually.
A term loan is paid back in predictable installments, often monthly. Payments usually include a portion of the principal plus a predetermined portion of the interest charges. So, for fixed-rate loans, you know approximately what you’ll owe and can budget ahead of time. It’s also possible to work with your lender to create a custom schedule that works for you.
With a business line of credit, interest begins to accrue as soon as you draw from your account but only applies to the outstanding balance. For example, if you use $20,000 out of an available $50,000 limit, you’re only charged interest on the $20,000. Interest rates vary based on credit score and lender but are usually moderate — somewhere between a credit card and a loan.
Interest for a term loan begins to accrue immediately and applies to the full principal. Charges are often baked into your repayment plan, which makes monthly payments more predictable. For example, if you take out a loan for $50,000 with an 8% interest rate and a 5-year repayment period, you’ll pay a total of $10,830 in interest. Interest rates for a term loan are often lower than for a business line of credit.
3. Type of credit
A business line of credit is revolving credit, meaning it provides continuous access to funds up to your credit limit. Remember that water tank with a tap you can turn on and off? Like a credit card, your available credit goes down when you borrow (the tank gets lower) and back up when you make payments (the tank replenishes).
A term loan is nonrevolving credit. Your loan is for a set amount of upfront cash that doesn’t replenish once it’s been spent. If you end up needing more money, you can use another type of credit to make up the difference or apply for another loan (financial experts don’t generally recommend using credit to plug a leaky pool).
4. Primary uses
A business line of credit gives you access to cash you can use at your discretion. It’s best to use it for expenses that can’t be charged to a credit card, like payroll and rent, because it can help you manage fluctuations in cash flow. It can also help you pursue urgent opportunities, provide a cash buffer against unanticipated costs or serve as extra cash between busy seasons.
Term loans are often limited to a single purpose. For example, if you take out an equipment loan, you can’t use that money for rent. Because a term loan typically functions as a long-term investment, it’s best used for a strategic purchase that will help your business expand, like a vehicle, equipment or property.
Which is right for you?
Here’s the bottom line. If you’re looking for flexible cash to help you cover various expenses, a business line of credit might be a better fit. If you need money for a specific purchase, a term loan might do the job.
Ultimately, credit is about strategy. Keep the big picture in mind and consider the long-term cost when making your decision. To learn more about your options, visit your local Chase branch.