Should I get a business loan or line of credit?
Business installment loans vs. lines of credit
- Business loans are used once, for one purpose.
- Business loans fund large expenditures, like building or equipment purchases.
- Business loans have fixed payments and payoff periods.
- Lines of credit are used as needed, for a variety of purposes.
- Lines of credit fund short-term cash flow needs.
- Lines of credit have lower, but variable interest rates.
Access to credit is usually essential to starting, operating or expanding a business. But there are credit options to choose from, depending on your business goals.
Two of the most common are business installment loans and business lines of credit. They are not mutually exclusive. Many companies have both business loans and lines of credit over the life of their business, and some have both at the same time. Knowing the characteristics of the two types of financing is key information if you are to tap the most useful and cost-effective funding for your business.
How to use
Business loans are used once and for one purpose. That is, the loan is funded fully as soon as it is approved and is intended to be applied to one long-term expenditure — such as a commercial property or the purchase of equipment. That's different from a business line of credit, which is used as needed.
The business draws on the line of credit to fund cash flow needs, including operating expenses and other short-term costs. The borrower pays interest only on the amount of money used, and the credit line can be renewed by paying back the outstanding draw on the loan. Business loans are one-time-only and do not renew.
Payments begin immediately after a business loan is funded, even if the business does not use the money immediately. With a line of credit, a business does not begin repaying the borrowed money until it is withdrawn and used.
The timing is different between business loans and lines of credit. Owners apply for a business loan when they need the money for a large purchase. But they get lines of credit before they need the money, in anticipation of predictable added expenses or sales slowdowns, and use the money periodically until their cash-flow improves.
What's the cost
You know the cost of a business loan when it's funded, unlike the costs of a business line of credit. Part of the reason is that you know the total amount that you're borrowing in a business loan, as well as the number of years you will have to pay back the money.
With a line of credit, borrowers have more payback options, including the choice of whether to make interest-only payments on the amount of the credit line used. In addition, business loans are more likely than lines of credit to come with fixed interest rates, while the interest rate on a credit line can vary, depending on fluctuations in the prime rate or other interest-rate benchmark.
Interest rates are usually higher on a business installment loan. So are closing costs, which can include origination fees, loan-packaging fees, guarantee fees if the loan is backed by the U.S. Small Business Administration, and fees to cover the cost of appraising collateral used for the loan. Lines of credit, on the other hand, have little or no costs associated with them other than the interest rate charged on the amount of money tapped by the borrower.