A business that requires financing typically has two choices available to them, a business loan or a line of credit.
As the business owner, you will be responsible for composing a funding plan. This will outline the amount that you will need to lend, the time frame in which it is required, and when you intend to have repaid it.
Gaining approval for either one of these loans will be determined by how you intend to use it along with your credit history.
Before taking out any type of loan you will need to conduct thorough research. Assessing the pros and cons of each type of funding will allow you to select the best option for your business needs.
If you are uncertain of the differences between a business loan and a line of credit, we have highlighted the characteristics of each in our guide below.
We also aim to help you to decide whether you should get a business loan or a line of credit.
What is a business loan?
A business loan, sometimes referred to as a term loan, is offered by a lender to fund a new business or support and help to expand an existing business.
In exchange for the sum of money that they receive, the borrower will be charged interest. This amount is repaid over a set period of time.
There are several types of business loans available, each of which serves a different purpose.
Long-term loans are intended for businesses that require a larger amount and are typically repaid over a prolonged period. For example, a long-term loan may be needed for purchasing purposes.
A short-term loan is used to cover immediate business expenses. For example, the money may be put towards daily operational costs, paying employees, or paying rent.
As expected, short-term loans will need to be repaid within a shorter time frame. In most cases, this will be between 6 months to 1 year.
Business loans are an ideal option for businesses who are aware of their continuing expenses. The goods that you purchase using this loan will then be declared by the lender as your collateral.
What is a line of credit?
A line of credit differs from a business loan but works similarly to a credit card in the sense that it allows businesses to borrow credit up to a certain amount.
Following approval, the institution will set a credit limit for the borrow. It offers lots of flexibility in the sense that it can be used repeatedly in full or in sections.
Simply put, a line of credit allows the borrower to withdraw money as it is required but they must remain within the set limit. As expected, your balance will gather interest over time.
A business line of credit can be used wherever it is needed. For example, this credit can be used to cover daily business expenses and even small-scale renovations.
It is of particular use to those who need immediate access to funds now and in the future.
The repayments will be made regularly, but of course, if you don’t withdraw any money you will not have a repayment to make. A business line of credit is also offered by banks, online lenders, and the SBA.
How does a business loan differ from a line of credit?
As you can see, business loans and lines of credit provide funds for business requirements, however, they do so in different ways.
Whilst they do also have a lot of shared similarities, there are many differences in the characteristics of each. We have highlighted these below.
The Type Of Credit
As we have touched upon, a business loan differs from a line of credit in the sense that it is paid to you in one installment.
Lines of credit, on the other hand, revolve meaning that you can carry this balance and you will only begin to make repayments once you have withdrawn funds from this balance.
With a loan, you will receive an amount that you will then need to repay every month, even if you don’t use the loan these repayments will still need to be made.
The Interest Rates
With a business loan, the interest rate is typically fixed. Essentially, the amount that you repay each month and the interest rate that you are charged per payment will remain the same for the duration of time that you are paying off the loan.
The interest rates for a line of credit however tend to fluctuate. Though the interest rate of this type of funding is lower than a loan, your monthly repayment figure will change according to this rate.
Secured vs Unsecured
When discussing business loans and lines of credit, you will discover that both are available in secured or unsecured varieties. Despite this, it is common to hear loans being referred to as secured and lines of credit being referred to as unsecured.
Now you may be wondering what the difference is between a secured and unsecured loan. Simply put, a secured loan is protected by collateral.
The borrower will pledge something valuable to the lender which they will receive should they default on the loan repayments.
As expected, an unsecured loan is the opposite. As such, no collateral is needed and a guarantor or assets are not used for protection. Instead, this type of loan is provided to those that have a strong credit history.
Whilst a business loan serves a specific purpose, a line of credit is a lot more flexible in the sense that it can be used where it is needed.
A business loan differs from this because it is used to cover a specific cost. For example, if you choose a loan to cover the costs of your equipment, you can’t then decide to use it to pay the wages of your workforce and vice versa.
How do you apply for a loan vs a line of credit?
A business loan and a line of credit are applied for similarly. There are many places where you can apply for a loan, this includes commercial or community banks as well as lenders online.
In some cases, depending on the status of your business, you may be able to apply for a loan through the SBA. There will be specific requirements in place and you will need to meet these before you are accepted for the loan.
You will need to provide information relating to your credit score, how long you have been in business, possible collateral, and financial statements.
You should expect the requirements for an SBA loan to be stricter and you will likely need to provide additional documentation with your application.
It is worth noting that your personal credit score may be considered along with your business credit score.
If your credit score could benefit from some improvement, you may have more success when applying for a loan through an online lender rather than a bank.
If you have bad credit, you will likely experience more challenges when trying to get approved for lines of credit. Similarly to a business loan, a line of credit is available through a bank or other type of financial institution.
Which financing option is best for you?
To determine whether a business loan or a line of credit is best for your needs, you will need to have a clear understanding of what exactly you require the funding for.
There are benefits and drawbacks associated with each so you will need to evaluate both options to decide which one you think is more compatible with your business.
Although a business loan offers less flexibility, it will have a fixed interest rate and a longer repayment period. For this reason, they are best suited to businesses that require long-term financing.
A line of credit is ideal for those who need access to the money with more immediacy. It is also ideal for those who need the money to cover smaller expenses such as inventory or repairs.
You also have the option to adjust your monthly payments if required, but you will need to remember that the interest rate is also more likely to fluctuate between payments too.
Ensure that you compile a plan and evaluate each of the options that are available to your business. If you don’t think either of these funding options is right for your business you can seek alternative options.