Cash is the lifeblood of business, and not having enough liquidity can stunt, cripple or kill your company. When businesses turn to borrowing to supply needed cash, they have a choice between a business loan and a line of credit. Both share certain features, in that they provide a cash infusion, must be repaid and charge interest, but as we shall see, these two funding methods differ in many ways and are geared to solve different types of problems.
What is a Business Loan?
A business loan is also known as a term loan, because it must be repaid by the end of a set time period—or term. Terms usually range from one to 20 years. A business loan resembles a mortgage, in that the borrower receives a lump sum and then repays principal and interest periodically, usually monthly—although some commercial lenders offer more frequent repayments. Most business loans are amortized, which means—when paired with a fixed interest rate—each payment will be for the same amount for the life of the loan, however business loans with interest-only payments or balloon payments do exist.
Typically, business loans charge a fixed interest rate over the entire term, although variable rate loans are available. Term loans are generally collateralized by a borrower’s business assets, such as real estate, equipment or inventory. In some cases, a business with a long track record and an excellent credit score might qualify for an unsecured loan. Term loan closing costs are usually higher than those charged for lines of credit. But remember: The interest rate on a collateralized term loan will likely undercut that of a line of credit.
An example of a business term loan might involve a company wishing to finance the purchase of computer hardware costing $200,000. The loan might be structured in this way:
- Loan amount: $200,000
- Loan term: Five years
- Interest rate: 6.25% fixed rate
- Collateral pledged: The computer equipment plus other company assets with a total value of $250,000 is pledged as collateral. The borrower provides the lender a lien on the pledged assets, meaning the lender can go to court and seize the assets if the borrower defaults on the loan.
- Closing costs: 3% of the loan amount, or $6,000, to be paid separately rather than deducted from the loan proceeds.
- Payment period: Monthly
- Payment amount: $3,889.85 per month. The early payments contain more interest and less principal than later ones, but the monthly payment amounts stay the same.
- Prepayment penalty: None
To obtain the loan, the borrower submits an application that is evaluated, or underwritten, by the lender. If they reach an agreement, they sign a contract that specifies all the loan terms and enumerates the pledged collateral. The borrower assigns a lien to the lender and pays the closing fees of $6,000 upfront, after which the lender deposits $200,000 into the borrower’s bank account. The lender draws monthly repayments automatically on the first of each month from the borrower’s bank account. When the loan is fully repaid, the borrower will have paid $33,391 in interest and $6,000 in fees.
What is a Business Line of Credit?
If a business term loan resembles a mortgage, a business line of credit is similar to a cash advance on a credit card, in that it is a revolving loan. That means you can access money up to your credit limit whenever and as often as you wish, repay the amount under flexible terms and borrow money that you’ve paid back as many times as you’d like. Interest rates are usually variable, meaning they change over time. Lines of credit are not generally not collateralized—although collateralized credit lines offer lower interest rates—and there is no set term to repay the borrowed amount, as long as you make the minimum payments each month. You only pay interest on the amount you actually draw from the credit line. If you never use your line of credit, you’ll never pay interest on it. Many credit line arrangements charge little or no closing costs.
Here is an example: A company establishes a $200,000 unsecured line of credit. It experiences a delay in collecting on a large invoice and needs to draw $30,000 from the line in order to meet short-term cash obligations. The loan might be structured this way:
- Loan amount: $30,000
- Loan term: None
- Interest rate: 9.75% variable rate
- Collateral pledged: None
- Closing costs: None
- Payment period: Monthly
- Minimum payment amount: The minimum payment amount is 3% of loan balance or $10, whichever is greater.
- Prepayment penalty: None
If the borrower were to repay the minimum amount each month, repayment would require 243 payments, and the total interest cost would be $11,076. This assumes the interest rate on the line of credit doesn’t change; if the interest rate increases, the total interest cost and number of payments would also increase, and vice versa. In this scenario, it’s likely the borrower would pay off the loan within three months, when the outstanding invoice is collected. The total interest would be smaller—under $1,000—depending on the amount of each payment.
Which Makes More Sense: A Business Loan or a Line of Credit?
Business term loans make the most sense when used for large, long-term financing, such as the purchase of fixed assets, creation, expansion or relocation of facilities, or investment in a venture. The reasons to prefer a term loan for large capital expenditures is that:
- Fixed interest rates: The interest rate is locked in so you know exactly how much you’ll have to repay each month. You won’t face higher interest rates as you might with a variable-rate credit line.
- Lower interest rates: A collateralized term loan usually has a lower interest rate than a line of credit does.
- Easy collateral requirements: The assets purchased by the loan serve as collateral for the loan, so that you don’t have to pledge a significant amount of other company assets.
- New cash flow opportunities The new asset might generate additional cash flows that can be used to pay down the loan. For example, an additional production line might increase your sales and lower your unit costs, giving you extra cash to pay down the loan over time.
- Accounting best practices: For accounting purposes, it’s appropriate to match the benefits of long-term assets with their long-term costs, repaid by long-term liabilities. For example, a piece of machinery might create additional revenue for the next 10 years, so it’s appropriate to finance its purchase with a 10-year fixed-rate loan.
A line of credit is more appropriate if the need for cash is short-lived. This can arise from uneven seasonal sales, opportunistic purchases of short-term assets like inventory, sudden unexpected expenses, temporary hire of additional staff and so forth. The benefits of using a line of credit for short-term purposes include:
- Fast cash: Cash is available immediately, without the wait it would take to obtain a term loan.
- No costs until you need money: There is no cost until you draw money from the line, and you pay interest only on the amount drawn.
- Draw, repay and reuse: You can reuse loan proceeds after you repay them.
- Payment flexibility: Monthly repayment amounts are flexible—you need repay only the minimum amount each month. For example, if you expect seasonal sales to pick up in four months, you can pay the minimum amount until higher sales revenues begin to roll in.
- No collateral or closing costs: You can avoid collateral requirements and closing costs.
In summary, term loans and lines of credits both provide businesses with an infusion of cash, but each has its more appropriate uses. Businesses should carefully weigh the costs and benefits of both when considering financing.