Are you about sourcing for your company and you want to know the best between a business loan and line of credit? If YES, here is a quick comparison to help you.
In the United States and in almost all countries of the world, if you want to start a business as an entrepreneur, there are certain structures put in place to ensure that you access loans or credit that can help you kick start your business or re-capitalize your business for expansion.
Research shows that small businesses are part of the economic drivers in most countries; so when it comes to accessing loan, there are options to consider and we will be looking at the business loan and line of credit.
The truth is that business loan and line credit are similar in some ways because they both make available capital for businesses and the loans must be repaid with interest. We will look at the difference between business loan and line of credit to determine which is the best for your business.
What is a Business Loan?
A business loan which is also referred to as Small Business Administration (SBA) loan or a term loan, is a business loan that is similar to a mortgage, because the borrower receives a lump sum and then repays both the principal and the interest from time to time, commonly monthly—even though some commercial lenders offer more frequent repayments.
Almost all business loans are prorated, which means—when paired with a fixed interest rate—each payment will be for the same amount for the life of the loan. Please note that there are business loans with interest-only payments or balloon payments available to borrowers and in all cases small business loans must be paid back by the borrower by the end of a set time period—or term and the time frame may be between one and twenty years.
It might interest you to know that business loans charge a fixed interest rate over the entire time frame or term as the case maybe, but you can negotiate for flexible rate on your loans from your financial institution. Term loans are commonly collateralized by a borrower’s business assets, such as real estate, equipment or inventory. We are not ruling out the fact that a business with a long track record and an excellent credit score might qualify for an unsecured business loan.
Please note that term loan closing costs are usually higher than those charged for lines of credit and the interest rate on a collateralized term loan will likely challenge that of a line of credit.
What is a Business Line of Credit?
In its simplest term, a business line of credit is just like a cash advance on a credit card because it is a turn – around loan. That means that you can access money up to your credit limit whenever and as often as you wish, repay the amount under flexible terms and borrow money that you’ve paid back as many times as you’d like.
A line of credit can also be said to be similar to a credit card or a home equity line of credit, where there are credit limits that the owner of the card can draw from till it reaches his credit limit. A line of credit is usually structured on a variable rate and can be adjusted periodically in line with the prime rate or other benchmark interest rate.
Interest rates are usually variable, that is they change over time. On the average, lines of credit are not collateralized—even though collateralized credit lines offer lower interest rates—and there is no set time frame (term) to repay the borrowed amount, as long as you fulfill the minimum payments agreed for each month.
You are only expected to pay interest on the amount you actually withdraw from the credit line. One good thing about line of credit is that if you never make use of your line of credit, you won’t pay interest on it. But that does not rule out the fact that a host of credit line arrangements charge little or no closing costs.
As an aspiring entrepreneur, it is only fair that you want what is best for your business when it comes to financing. However, in determining what should be the best financing option for your business as an aspiring entrepreneur, you will need to check on the advantages and disadvantages between both options. Some of the factors you can use to do this are;
Business Loan Vs Line of Credit – A Quick Comparison
- Timing-: While a line of credit can be set up long before you need it and can serve various purposes, a loan is usually applied for when it is needed and it must be used for a specific purpose.
- Renewal-: A business loan cannot be renewed even after the term has ended, as a new loan must be applied for again; this is unlike a line of credit which is usually revolving and can be used as many times as possible.
- Monthly Payments-: When you take a business loan as an entrepreneur, you usually have to pay back your loan monthly regardless of whether you have started using the loan or not. However, with a line of credit, your payment only reflects the amount which you have borrowed and so if you have a balance that is zero, you will not need to pay anything.
- Terms or Repayment Periods-: The terms of repayment for a business loan are usually fixed which makes the monthly repayment higher when compared to a line of credit.
- Closing Costs-: The closing costs are usually higher for a loan than for a line of credit. The closing costs for most loans usually include processing; appraisal (for loans that come with collaterals) and credit check fees and can fall between 2 to 7 percent of the overall cost. That of line of credit usually includes processing, credit fee, withdrawal or transaction fees (for additional cash against the line of credit) and is usually charged at the barest minimum.
- Interest Rates-: Interest rates vary depending on the financing option. For instance, for a business loan, the interest rates are higher and it is usually fixed; while a line of credit usually offers the entrepreneur lower interest rates that are variable. However, one thing with a line of credit is that late repayment or exceeding the credit line might cause your interest rates to increase. Therefore, those that use line of credits have to be wise so as to be able to lower their rates.
- Long-term vs short-term-: A business loan, both principal and interest, usually has to be paid off within 1 to 10 years, this is why a loan is best for long term purposes. Lines of credit on the other hand, are meant to be repaid within a short period and best for short term purposes. Those who use lines of credit usually use it for account receivables such as payroll or marketing.
Things You Need to Know Before Choosing a Business Loan or a Line of Credit
Before making a choice on which process you want to follow to access money for your business, it is important to clearly look at your business goal and the opportunities that are available to you. For example, by its characteristics, business term loans are more suitable when you want to access large pool cash or long-term financing for the purchase of fixed assets, expansion or relocation of facilities, or investment in a venture.
Here are some of the positives why you should go for business loans as against line credit when sourcing for fund to finance all major business needs or investments.
- Business Loans Have Fixed Interest Rates
Unlike line of credit, with business loan, you are certain that your interest rate is fixed and you know exactly the amount that is expected of you to repay each month. The advantage is that you are not going to be grappling with higher interest rates as you are likely going to face with a variable – rate line of credit.
- Business Loans Have Lower Interest Rates
In the United States and in some of countries of the world, the fact that small business loan is a collateralized term loan means that it will come with a lower interest rate. This is so because a collateralized term loan usually has a lower interest rate than a line of credit does.
- Business Loan Has Easy Collateral Requirements
Unlike line of credit, with business loan, the assets purchased by the loan in addition with few company’s assets serve as collateral for the loan. For example, if you access a loan of $100,000 to purchase distribution vans for your company, the distribution van and perhaps any of your asset that is worth about 3 percent of the loan will be used as collateral. It goes to show that you are not required to lay down a significant amount of other company assets before you can access a business loan.
- Business Loan Gives You Opportunity to Access Large Funding for Your Business
When you access business loan for your business, it means that you will have enough cash to purchase asset that will help you drive growth for your business. For example, if the business loan you accessed is used to purchase a bigger production machines for your business, it means that your production capacity would have increased and that would mean more supply to your customers and ultimately more income for your company.
- Business Loan Operates on Best Practices in the Accounting Industry
Unlike line of credit where you can draw cash from your credit card at time you so desire, it is not so for business loan. If you are concerned in keeping your book unambiguous as a business owner, then going for business loan as against line of credit is a better option for you.
An accountant will always advice that if you are borrowing to acquire asset for your business, it is most appropriate to compare the benefits of long-term assets with their long-term costs, repaid by long-term liabilities. For example, an asset (production machine) might create additional revenue for the next 5 years, so it’s appropriate to finance its purchase with a 5 -year fixed-rate loan.
Now let us look at Line of Credit;
If the purpose of borrowing is just to access cash to take care of immediate business needs for a short period, then your best bet is to access line of credit. Businesses do go through downturn and that can hamper cash flow and cash flows are needed to take care of some overhead on a regular basis and that is where line of credit becomes appropriate.
- Line Credit is Highly Suitable When You Need Quick Cash
One of the advantages of line of credit is that cash is always available whenever you need it and unlike business loan, you don’t have to go through the rigors of paper work, submitting collaterals and meeting with your lenders before you can access cash; you can make withdrawals from your credit card and from any ATM machine around you.
- Line of Credit Can Only Charge You When You Make Withdrawal
Unlike business loan that has services / business charges and perhaps other hidden charges, you are not expected to pay any charges with line of credit unless you withdraw money from the line, and you pay interest only on the amount drawn.
- Line of Credit Comes with Payment Flexibility
With line of credit, the amount you are expected to repay on a monthly basis is not fixed; they are flexible. All you need to do is just ensure you pay the minimum amount that is expected of you to pay and you will be just fine to keep your credit ratings. With line of credit, you are not expected to be under any undue pressure especially if you are not meeting your set target as it relates to the sales or revenue you are expected to generate in order to clear your debt.
- No Collateral Required to Access Line of Credit
With line of credit, you are rest assured that you are not presenting any collateral or closing costs when accessing credit for your business and as a matter of fact, you can continue to withdraw, as long as you are not a defaulter. With that you can access enough cash to do something reasonable for your business.
In conclusion, we cannot categorically state that one is better than the other because they both serve different purposes and as a business person, the reason why you want to access funds for your business should guide you on whether to go the route of business loan or line of credit.