Compare Small Business Loans
For small businesses, the key word is “flexibility”—you never know when you might suddenly need extra cash, either to pounce on a new opportunity, survive a sudden lull in sales or pay for unexpected expenses. Frequently in these circumstances, the most convenient way to access funds is to borrow money, and business lines of credit and business credit cards are popular sources of funds. Here, we compare the two options and evaluate the scenarios in which one might be better than the other.
- What is Revolving Credit?
- How Does a Business Line of Credit Work?
- What is a Business Credit Card?
- Business Line of Credit vs Business Credit Card
What is Revolving Credit?
Revolving credit accounts allow you to borrow up to a preset limit—after which you must repay the borrowed amount before you can borrow it again. You are allowed to borrow and repay from your credit line as often as you like, as long as your account remains in good standing and you don’t exceed your credit limit. You pay interest only on the money you actually borrow, and not the full credit limit. Contrast this against a term loan, where you borrow a fixed amount upfront and repay it, with interest, in fixed installments without the ability to reborrow the same funds. Both business lines of credit and business credit cards are revolving accounts, however each is distinguished by a few factors that we identify below.
How Does a Business Line of Credit Work?
A business line of credit allows you to instantly borrow money as needed, and then repay those funds in fixed monthly installments, with interest, over time. You apply for a business line of credit with a bank, credit union or commercial lender in pretty much the same way you would apply for a term loan. If your application is approved, you are provided a set of checks or a debit card that allow you draw upon the line up to the set credit limit. You might also be able to transfer funds electronically between the line and your business checking account. In many ways, a business line of credit behaves like a hybrid option between a credit card and a term loan.
Like term loans, some business lines of credit require collateral, while others don’t. Generally, secured credit lines charge lower interest rates because the collateral secures the lender’s interest. Unlike term loans, you pay no interest unless you actually draw funds from the line, and you pay interest only on the unpaid balance. You can repay the balance at any time, either in its entirety or in installments. Business lines of credit typically have fixed repayment amounts that require you to repay a draw within six months to one year.
For example, your business might apply for a secured line of credit from the bank where you maintain your business checking and savings accounts. You apply for a $20,000 credit line, collateralized by certificates of deposit your business maintains at the bank. The bank agrees, giving terms of 20% annual interest, which amounts to daily interest of 0.0548%, and a monthly repayment amount of 10% of each draw.
You subsequently draw $5,000 from the line of credit, which decreases your available credit line to $15,000. After 30 days you’ll be charged $82.19 in interest, plus 10% of the $5,000 of principal outstanding. Once you’ve paid your first monthly installment of $582.19 ($500 principal + $82.19 in interest), your total available credit line will become $15,500. The $500 which you’ve repaid is now available to borrow again.
Each draw on a line of credit has its own fixed repayment schedule, so a line of credit with a series of outstanding draws behaves like a collection of term loans. The distinguishing traits here are that: 1) you can borrow what you need on a revolving basis and 2) you incur interest only on the amounts that you borrow. The interest on a business line of credit is also tax-deductible as long as the borrowed money is used only for business purposes.
What is a Business Credit Card?
A business credit card works like your personal credit card, but should only be used for business expenses. You can use it for purchases or cash advances, and you pay interest only on your outstanding balance. Business credit cards are unsecured and the credit limits are based on your creditworthiness. Credit card interest rates are usually higher than those of lines of credit, especially secured lines of credit, but the interest on credit card purchases doesn’t start accruing until 30 - 45 days after it's incurred–typically the start of the next billing cycle. However credit card cash advances begin accruing interest immediately and are the exception to this rule.
As an example, you have a business credit card that charges 18% on purchases and 24% on cash advances. Your business suddenly needs $5,000 in cash, which you obtain via a cash advance on your business credit card. The annual interest rate on cash advances is 24%, or 0.0658% per day, on the outstanding balance. You borrow the money for 30 days and then repay it in full. Your interest charge is $98.63. Notice that amount is more than the $82.19 you’d have paid on the example line of credit, because the credit card charges a higher interest rate. The credit card company might also charge you a separate transaction fee for each cash advance.
As an alternative example, suppose your business needs to purchase $5,000 worth of inventory. However, instead of obtaining a cash advance, you charge the full amount as a purchase to your business credit card. The annual interest rate on your credit card purchase is 18% and your billing cycle lasts 30 days. On the 30th day of your billing cycle, you repay the $5,000 in full. As a result, your interest charge for the borrowing period is $0. Notice that if you’re able to repay your borrowed amount in full within the initial billing cycle, you can avoid interest charges altogether.
Business credit cards usually allow an initial grace period for purchases where no interest is incurred, which makes them ideal for day-to-day purchases that you intend to repay within a month. However the interest rate on credit card cash advances can often be more expensive than a comparable line of credit. Assuming you don’t repay your credit card and carry a balance from month to month, business credit cards will require you to pay a minimum monthly payment, plus interest, and may also charge an annual fee. As long as you use your business credit card exclusively for business expenses, the interest and purchases are tax-deductible.
Business Line of Credit vs Business Credit Card: Which Makes More Sense?
Here are some examples in which you might prefer using one option over the other.
Rewards: Business credit cards usually provide rewards for usage, such as loyalty points or cash back, which you can then apply to other business expenses, such as business travel. This does not apply to credit card cash advances. By comparison, business lines of credit don’t usually offer rewards. For this reason, you might prefer to use your business credit card for purchases, so that you can accumulate rewards, and your line of credit for your cash needs.
- Advantage: Business credit cards
Collateral: Most business credit cards are unsecured, which means you don’t have to tie up your business assets as collateral. By contrast, many lines of credit are secured, which means you will have to pledge some of your business assets as collateral. This may prevent you from selling them for other purposes. Startups frequently have little in the way of collateral, making credit cards a more viable option. If you don’t want to risk your assets, you might find a credit card to be a better source of borrowing.
- Advantage: Business credit cards for startups, business lines of credit for established companies
Interest rates: Credit cards usually charge greater interest rates than lines of credit. However, if you use your credit cards only for purchases and not cash advances, and you always pay off your balance each month, you won’t be charged interest on the card because of the grace period. Lines of credit have no grace periods, which means they are costlier if you do pay off the balance in the next billing cycle. Therefore, credit cards are the better choice for purchases when you don’t let balances accumulate.
- Advantage: Business lines of credit for cash advances, business credit cards for short-term purchases
Credit limits: In general, lines of credit allow higher credit limits of up to $250,000 or more, if they are secured, compared to credit card limits of up to $50,000. Banks are often reluctant to extend lines of credit beyond their limit, and may even require accelerated repayment if you consistently hit your limit. By contrast, credit card issuers will often negotiate a higher limit if needed, provided you have a good or excellent credit profile. In general, if you need access to larger borrowed sums, you’ll be able to borrow more from a line of credit than a credit card.
- Advantage: Business lines of credit
Fees: Some lines of credit charge an origination fee of 1% to 5% when you establish the line, and/or charge a transaction fee of about 1% of each draw. Outstanding lines of credit with no account activity for a year might also be charged a 1% dormancy fee. In comparison, credit cards can also have numerous fees, but usually not an origination or dormancy fee. Credit cards can also assess late payment fees and cash advance fees, and many charge annual fees in some cases. If you are fee-sensitive, be sure to compare the fees on your best offers for both lines of credit and credit cards.
- Advantage: Neither
Employee expenses: You can more easily manage employee expenses by adding authorized users onto your business credit card account. You can review all charges every month to police proper usage. The credit card statements give you a convenient record of expenditures made by employees for your tax filings, and you can receive card rewards for employee purchases. Lines of credit don’t offer a similar facility, and you probably wouldn’t want to give employees access to the line anyway. Therefore, credit cards might be a better choice if they are shared between the owner and employees.
- Advantage: Business credit cards
Low credit score: The minimum credit score requirements for a business line of credit might be lower (around 550) than those for a business credit card (around 640), especially if the line is secured. Therefore, if your business is a startup or you have a poor credit score, you might have better access to credit via a line of credit rather than a business card. Prospective borrowers should beware that lines of credit often employ more complicated application processes than a business credit card.
- Advantage: Business lines of credit