Are you trying to pick the best between a term loan vs line of credit? If YES, here is a detailed comparison between term loans and business line of credit.
If you are in need of funds to start up a new business or expand what you already have on ground, a line of credit and a term loan may be some of the options that will come to your mind. Both of them are types of financing that a business can make use of for its needs. But the question that usually comes up in the mind of entrepreneurs is which of the two options is the best.
Term Loan Vs Business Line of Credit – Which is the Best?
What is a Term Loan?
Term loans come in large sums which can be paid back over a given period of time in addition with the interest and fees. This type of loan can be repaid within a range of one year to twenty years. As soon as you exhaust the existing funds, you will have to apply for another loan if you are in need of further financing.
A lot of business loans are secured, in the sense that they require you to bring a form of collateral which can be in form of an equipment, real estate, or a lien on your assets.
Term loans work best for the borrower if he has long term investment plans. For example, if you intend to buy capital equipment or some other type of fixed asset that will take you a long time to pay off- say a couple of years, buying an existing business et al.
Another example of a situation when you can use a term loan is if you own a restaurant and you would wish to expand the business to a space that just recently became available next door. The expansion will take you some time to pay off therefore it will be advantageous to go for a term loan that you can pay up over a period of years.
The longer you have owned and managed a business, the easier it will be for you to be able to get a term loan because, the banks will want to make sure that you have consistently succeeded in the past.
What is a Business Line of Credit?
A business line of credit can be compared to a credit card in the sense that you get a specified amount of funds from which you can withdraw from whenever you need it. If you decide to go for a business line of credit, you will be mandated to pay interest on only the amount of money that you have made use of. You will have to repay the amount you drew over a set period of time, after which you can renew your credit line.
A situation whereby you can use a line of credit would be if you own a business selling fashion accessories from a shop and a particular style of hats is selling quite fast. You need to order more and your supplier is offering a great deal but requires cash on delivery. You can make use the line of credit to pay for the hats then pay back as soon as you sell.
Benefits of Term Loans vs Line of Credit
- It offers a fixed or variable rate of interest: A lot of lenders will give you the option of choosing to go for a loan that has a definite interest rate or one that changes as the market rate changes. Variable rates usually start lower but can increase over the term of the loan.
- The repayment plans are flexible: Some of the loans will offer you multiple repayment options from which you can choose the exact amount you will pay back and when you will pay back. You can choose you pay back your loan on a daily, weekly or monthly basis.
- Discounted rates: in return for paying interest on a sizable loan, the lenders at times offer discounts for things such as setting up automatic payments.
- Term loans usually grant higher amounts of money.
- The interest rate of term loans tends to be lower when compared to line of credit.
Line of Credit
- You only pay interest on what you use: instead of having to pay interest on a lump sum, line of credit offers you the advantage of paying interest only on what you have used.
- Option to renew: using a line of credit, you can choose to renew it. A lot of businesses have line of credit with a specific lender for years which they renew from time to time.
- Withdraw any time you choose: lines of credit offers a business owner the ability to withdraw up to a daily or card limit at any point in time and thus, it makes it a really convenient option for business owners who have ongoing expenses or have the intention to prepare for a large unexpected expense.
- line of credits are easier to get when compared to term loans
Drawbacks of Term Loans vs Line of Credit
- Does not lend help to cash flow: term loans are not that good for covering unexpected gaps in your cash flow, because you will need to calculate the exact amount of money you need to borrow when you apply.
- It is not flexible: when you take a term loan, you are expected to start repaying it immediately even if you end up not using all the money you borrowed.
- It takes effort to get more financing: if you have been using a term loan and you need additional funds, you will have to go through the application process over again as opposed to simply renewing it.
- The approval process can be quite long and strenuous.
- The closing costs can be quite high a times
Lines of Credit
- Not the best option for large purchase: it is possible to max out your credit limit on a new piece of equipment, you will not have any other funds available to cover expenses until you have paid it off.
- Repayments can be unpredictable: using a line of credit, you will notice that your monthly repayments go up each time you draw from your credit line. If you do not have a definite idea of the amount you will be drawing, it can be difficult to calculate a budget for loan repayment
- Draw fees: a lot of lenders are known to charge a withdrawal fee each time you want to draw funds from your credit line. This draw fee is usually about $25.
- Line of credit comes with terms and conditions for you to continue to enjoy access and in the event you fail to comply with any of these terms and conditions, your access can be revoked.
- They can be “pulled” by the lender at any time for any reason such as if the lender is having issues with liquidity.
- Lines of credit provide smaller amounts of money when compared to term loans.
What Type of Costs Does Term Loans and Line of Credit Cover?
Term loans are best for large, one-time purchases or specific purposes. You can use them for the purchase of equipment, real estate, vehicle, business acquisition et al. Line of credit on the other hand are best for covering smaller, short term expenses that are hard to predict such as overhead costs during an off season, restocking inventory, payroll, emergency expenses et al.
Having weighed these options the next issue that needs to be surmounted is which to go for? The best recommendation will be to get both the term loan and the line of credit. You should get a line of credit to handle your day to day working capital and cash flow needs and then get a term loan for larger projects or more significant working capital.