10 differences between business loans and a line of credit
Almost every business needs investment from time to time, either to start up, buy stock or provide essential funds to expand. Businesses also need funding to cover short term cash-flow issues. Some businesses may have cash to fund these requirements but many will need to turn to a business loan or line of credit. It is important to know the differences between business loans and a line of credit so that you can choose the approach which is right for you and your business.
A line of credit is set up in advance, ready to use if and when you need it. A business loan can usually only be set up when there is already a specific need for funding. This can be problematic for urgent funding requirements.
2. When you pay
You will have to start making monthly repayments on business loans straight away whether or not the business has used all of the funds advanced to it. A line of credit is more flexible because you only pay if there is an amount outstanding. If your balance is nil, there will be nothing to pay.
3. Business loans provide funding once, lines of credit are on-going
A business loan usually provides one injection of finance to meet a specific need. A line of credit remains open for the business to call upon as many times as necessary up to the agreed limit. Lines of credit are a useful backup source of funding for businesses to have in reserve, ready to use if required.
4. Business loans are a long term commitment
Business loans are best for long term debts which you intend to pay off over 2 to 6 years. This makes business loans ideal for strategic investment projects in your business. For shorter-term finance needs and cash-flow issues, lines of credit are more flexible. Conversely, lines of credit are not as suitable for long term funding because they usually include a clause allowing the lender to call in the funding at its option.
5. Repayments on business loans are usually fixed
The repayment schedule for a business loan is usually fixed at the outset. The repayments on a line of credit vary according to the amount currently outstanding.
6. Business loans have higher interest rates
Business loans usually have fixed interest rates which do not vary over time. These fixed rates tend to be higher than the variable rates on a line of credit. With good management, a line of credit is often cheaper than a business loan, provided that you are not late with payments or go over your credit limit.
7. It costs more to close a business loan account
Most loans incur costs to close the account, with some form of early redemption clause almost invariably included in the agreement, whereas the costs to close a line of credit are either nil or minimal.
8. Business loans are driven by interest rates
The costs of lines of credit are not as sensitive to interest rates as business loans. The cost of a business loan is usually driven by the market’s prevailing interest rates. Lines of credit are generally used for shorter-term finance and so it is more important for a business to have a low monthly cost than a fixed interest rate.
9. The fees differ
The fees for a business loan will include an application fee and closing fee. A line of credit will have ongoing fees, for example, transaction fees may be charged on each drawdown.
10. Lines of credit offer a more flexible drawdown schedule
A business can call on a line of credit as and when it needs it without the need for prior approval of the purpose for drawing on it. The business can use as little or as much of the line of credit as it actually needs with no need to draw the whole amount authorised by its credit limit. A business loan can generally only be drawn in a lump sum whether or not the business needs the entire amount all at once. Once the loan has been issued, monthly repayments on the whole amount start.
In summary, whether you choose a business loan or a line of credit for your business depends on many factors. However, as a general rule, lines of credit should be reserved for revenue-generating activities with business loans used for longer-term ongoing investment.