While searching for small business financing options, you might have come across two popular loan programs: A business loan and a business line of credit.
Both these loan programs have important similarities and offer small business owners quick access to the capital they need for a variety of business purposes. However, they also differ in some ways as well. Understanding the difference between a small business loan and a business line of credit can help make you the perfect choice when determining how to finance your small business.
Small Business Loans
A small business loan is the most popular financial product where you get a fixed amount of money to fulfill your financial needs. Most small business loans offer smaller loan amounts as compared to commercial business loans to provide borrowers a good possibility to repay the loan easily.
The idea behind a small business loan is simple: you request funding via a loan application and once approved, you can have the funds requested in your bank account. The repayment is made over a predetermined period in monthly increments with interest.
Getting a small business loan from traditional lenders is generally difficult. Traditional lenders have strict qualification requirement and they tend to work with larger, established businesses with good credit profiles.
Alternative lenders (online lenders) on the other hand offer more flexible and convenient lending requirements for small business loans approval – allowing small businesses to qualify instantly and at flexible rates and terms
Business Lines of Credit
Business lines of credit work the same way as credit cards do. You get a lump sum of money that you can withdraw from your approved credit limit. After you pay off the principal with interest, your credit limit goes back up. A business line of credit differs from a small business loan due to its revolving nature. With a small business loan, you get a single, lump sum of money, whereas, with a business line of credit, you can use cash repeatedly up to your approved credit limit. As long as you make the minimum timely payments, you can access your credit limit again.
The credit limit provided by a business line of credit is often lower than the amount provided by a small business loan. The application of a line of credit is typically different from a small business loan.
You can use a business line of credit for the same purposes as you would use a small business loan. However, financing large expenses is difficult with a line of credit, because of the smaller loan amounts. A small business line of credit is used for small regular business expenses and to manage cash flow issues.
Small Business Loan vs Line of Credit: The Difference
A small business loan is typically used to finance long-term credit needs, and a line of credit is for short-term needs. There are many other differences between these two financing options. Here are the key differences between these two loan options:
- Interest Rates
For a small business loan, the interest rates are fixed and you make fixed interest payments on the entire loan amount.
For a business line of credit, the interest rates are variable. You will only pay interest on the amount you used on a line of credit.
A business line of credit generally has a lower interest rate as compared to a small business loan.
- Loan Payment Terms
For a small business loan, you pay fixed monthly payments whether or not you are using the entire loan amount.
For a business line of credit, you only make payments on the amount you actually used from your credit line. To put it simply, if your balance is zero, your payment is also zero.
- Loan Fees
For a small business loan, you pay for the loan origination fee, processing fee, appraisal fee, and prepayment penalties.
For a line of credit, you pay for the initial processing fees along with the fees associated with each draw you make.
Not to mention, the closing cost of a small business loan tends to higher than a business line of credit.
How Do You Know Which Loan Option Makes Sense?
Small Business Loans
A small business loan makes more sense when you need funding for long-term financial needs, such as assets purchase, expansion or investments. Here are a few things to consider when taking out a small business loan:
- Fixed interest rates
- Lower interest rates
- Easy collateral requirements
- New cash flow opportunities
- Accounting best practices
Business Lines of Credit
A line of credit is more suitable when you need cash for short-term needs. Here are a few things to consider when taking out a business line of credit:
- Quick availability of cash
- No costs until you need money
- Draw, repay and reuse
- Payment flexibility
- No collateral or closing costs
Which Loan Option Is Best for You?
Both financing options have their pros and cons, and comparing them can help you to decide which option is best for your small business’s unique needs.
Pros of Small Business Loans
- Larger loan amounts
- Financing for long-term expenses and investments for longer periods
- Predictable loan payments
- Fixed interest rate
Cons of Small Business Loans
- No flexibility once you’ve borrowed the money
- Closing costs like underwriting and appraisal fees
- You have to make monthly payments whether or not you use the money
- Collateral might be required
Pros of Business Lines of Credit
- You can use as much money as you want from your approved credit limit
- Reusable loan amount up to the amount of your credit limit
- Helps even out cash flow during slow seasons
- Offer lower interest rates than a fixed-rate small business loan
Cons of Business Lines of Credit
- Shorter repayment terms
- Low borrowing limits
- Likelihood of penalty interest rate increases on late payments
- Make financial planning difficult due to unpredictable payments
How to Choose the Best Loan Option for Your Small Business
Understanding the key differences between both financing options can help you determine the best possible option based on your business needs. The best way to determine your loan option is to do your due diligence. Early preparation for the loan application can not only save you a lot of time and effort but also get you the best possible solution for your financial needs. The key is to plan, compare your loan options, and most importantly, take your time in order to make an informed loan decision.