Term Loan VS. Line of Credit
When it comes to small business funding, are term loans or lines of credit a better fit for your small business? Find out with this guide.
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Key Takeaways
- Term loans are ideal for businesses that need a large lump sum of capital for specific expenses. They generally have lower interest rates but use a structured repayment schedule.
- Lines of credit are best for managing ongoing or unexpected expenses. They generally have higher interest rates but offer more flexibility than term loans.
- While lines of credit often have less stringent borrowing requirements, borrowing limits are often lower and repayment terms are shorter than term loans.
If you need to fund your business, you might be researching different loan types and structures. So, it’s important to understand the similarities and differences between two popular ways to finance your business: term loans vs. lines of credit.
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Term Loans VS. Lines Of Credit: A Quick Glance
Disclosure: This video is sponsored by Lendefied and is included for informational purposes.
Here’s a quick breakdown of the differences between term loans and lines of credit, and situations where you might choose one over the other.
You might want a term loan if:
- You know exactly how much money you need for a particular expense
- You don’t already have access to credit and need money quickly
- You need a large lump sum of money
- You need a lot of time to pay off your loan
- You have a strong credit score
- You have been in business for two years
You might want a line of credit if:
- You foresee having a lot of smaller expenses over a more extended period
- You want access to cash when you need it
- You want to have a financial cushion to fall back on if unexpected expenses arise
- You want a reusable source of funding
- You have a credit score of 650 or higher
- You have been in business for six months or a year
What Is A Term Loan?
Term loans or installment loans usually deliver funding in a single lump sum. Repayment begins once you’re approved and receive the funds, but it’s spread over a set period — hence “term” loan. Interest is factored into your payment structure. Payments may be made weekly or monthly, depending on the lender and loan terms. The lender will set an interest rate based on the type of term loan, your business credit score, and your business’s fiscal health.
Rates can range widely depending on the lender and borrower, from around 5% to 30% or more. Short-term loans tend to have rates that are less favorable than intermediate- and long-term loans, with the upshot being that the latter two are harder to qualify for.
The longer your loan term, the more you’ll pay in interest. As you shop around, do your best to find the best balance between immediate access to funds and long-term expenses.
Approval speed depends on the type of lender, as well as the terms of the loan. Online lenders tend to approve and fund loans faster.
The Main Types Of Term Loans
| Type Of Term Loan | Short-Term Loan | Intermediate-Term Loan | Long-Term Loan |
|---|---|---|---|
| Claimable funds | At least $1,000 to $5,000, possible to qualify for tens or hundreds of thousands | $500,000 to $750,000, possible to qualify for more | Up to several million dollars, depending on the lender |
| Time for approval | Could be as little as two to three days | A week or less via non-traditional lenders; weeks or months through banks or the SBA | A week or less via non-traditional lenders; weeks or months through banks or the SBA |
| Payment structure | Six months to a year, sometimes 18 months | One to five years | Five years minimum, upwards to 20 or more |
| Interest owed | Typically fixed-rate between 8% and 13% | Between 6% and 30%, can be fixed or variable | Varies based on payment structure |
When Is A Term Loan A Good Decision?
Term loans are ideal for established businesses that are attempting to expand, need to make a large purchase, or otherwise have a one-off expense of some kind.
Do note that you should take into consideration the long-term value of what you want to purchase with your loan. If you’re purchasing a piece of equipment or a vehicle that depreciates in value so quickly that it’s worth less than the debt you’ve accrued, you’ll likely want to opt for a short-term loan or a different source of funding altogether.
How Do I Qualify For A Term Loan?
There are typically stronger approval odds with higher credit scores (often 650–700+) and at least 1 to 2 years in business. But the type of loan you apply for also plays a part.
Short-term loans are easier to get than long-term loans since they typically provide less capital and fewer risks to the lender. Whether it’s a secured vs. unsecured loan will affect your chances as well.
Some lenders will still give you loans with bad credit, especially if you’re able to demonstrate that your business can responsibly handle payments.
Many lenders require consistent annual revenue, often $100,000 or more, though requirements vary. Talk with the lender to get familiar with their requirements.
What Is A Line Of Credit?
Instead of offering you a lump sum, a line of credit gives you access to a set credit limit. You can draw upon that credit at will, borrowing up to your credit limit.
Rates can vary widely depending on the lender and borrower, from single digits at traditional banks to much higher rates with alternative lenders. The same is true for limits — some banks will extend millions in credit. Other lenders may only offer $250,000.
Where you apply — along with your credit profile and business finances — affects your limit and rates.
Similar to a business credit card, most lines of credit are revolving, meaning that your funds become available again as you pay off your debt. Some lenders offer rewards programs similar to those of credit cards as well.
The Main Types Of Lines Of Credit
| Type | How It Works |
|---|---|
| Unsecured Line Of Credit | An unsecured line of credit is simply one that isn’t secured by an asset. Although there is no formal collateral per se, you may be asked to sign a personal guarantee. |
| Asset-Backed Line Of Credit | A line of credit that bases your credit limit on an asset. If the value of your asset changes, your credit limit may change as well. |
| Invoice-Backed Line Of Credit | An asset-backed line of credit that uses your invoices as security. Not to be confused with invoice factoring. |
| Home Equity Line Of Credit (HELOC) | A line of credit that uses the equity you’ve built up in your home as security. HELOCs often have a draw period of around 10 years with interest-only payments, followed by a repayment period. |
When Is A Line Of Credit A Good Decision?
Lines of credit are best for businesses looking to smooth out their cash flow or who want to have a reserve fund they can use to pay for unexpected expenses throughout the year.
Rates can be higher depending on the lender and flexibility offered.
How Do I Qualify For A Line Of Credit?
You may be able to qualify for a line of credit if you have a credit score of 650 or higher and you’ve been in business for at least six months or a year. Qualifying with a lower credit score is a possibility if you can prove that your business has a strong annual income.
At the very least, be prepared to show that your business earns $120,000 a year at minimum. Ask the lender about their requirements.
Term Loan VS Line Of Credit: Key Differences
| Term Loan | Line Of Credit | |
|---|---|---|
| Repayment Periods | If you need a large chunk of money and a long time to pay it off, a term loan can grant you that flexibility. This doesn’t necessarily apply to short-term loans. | You can have some flexibility with a line of credit, depending on your limit and usage. But be aware that the interest rates on lines of credit tend to be higher, so keeping yourself in debt will cost you more over time. |
| Ease To Acquire | Alternative lenders have been growing in popularity and are more likely to approve businesses for loans. However, you may wind up with a higher interest rate or a term that’s shorter than what’s ideal for you. | Approval requirements can be strict, especially with traditional lenders. |
| Rates | Term loans often have lower rates than lines of credit, depending on the lender. | In most cases, you’ll pay a premium for the convenience a line of credit offers, whether in interest rates or fees. |
| Convenience | Term loans require you to apply every time you need more cash. On top of that, you risk stacking loans if what you qualified for doesn’t cover your expenses. Short- and intermediate-term loans may also have balloon payments. | Lines of credit can make day-to-day expenses easier to navigate since you can draw money whenever you need. And with a revolving line of credit, those funds replenish, sparing you from having to reapply. |
Is A Term Loan Or A Line Of Credit Right For Your Business?
Whether a term loan or a line of credit is best for your business heavily depends on the type and size of your expenses.
If you need a lump sum, know exactly how you’ll use the funds, and can pay the money back over the next few years, a term loan might be best. Our small business loan reviews can help you find a lender that works for you.
If your financial needs are less defined and your ability to repay quickly is more solid, a line of credit may be the way to go. In that case, we can help you find the best business lines of credit as well.
Best of luck!
Chelsea Krause
Expert Contributor
Chelsea Krause is a writer who specializes in accounting, payroll, and small business loans. She has been helping small business owners manage their finances since 2016. She is a QuickBooks Certified User and former eCommerce store owner. Her accounting expertise has been quoted in Forbes and her work appears in Startup Nation, Small Business Bonfire, and Women on Business. Chelsea graduated summa cum laude with a BA in English & Creative Writing from George Fox University and studied abroad at the University of Oxford as well.
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