Term Loans and Lines of Credit: What’s the Difference?
Term loans and lines of credit are both good financing options, but how are they different and which one is best for you?
Accessing financing from an outside source can be a great way to grow your small business, but with so many different types of external financing, it can be difficult to choose the right option for you. While an injection of capital can be just what your business needs to reach its goals, choosing the wrong type of financing or agreeing to unfavorable terms can damage your business’ financial health. A cash flow crunch, high APR, and short repayment terms can make it harder to keep your business running smoothly. This guide explores the differences between term loans and lines of credit, so you can make the best decision for your business.
Term Loans and Lines of Credit: The Basics
A term loan is a lump-sum of money provided upfront by a financial institution to the borrower in return for pre-determined repayment terms. Repayment terms include the payment schedule, interest rate, and term, or length, of the loan. Term loans are commonly offered by banks, credit unions, and online lenders. A line of credit is a pre-approved variable-amount loan or borrowing limit that you can draw on at any time without having to justify the use of the funds. Lines of credit are almost always provided by a bank or credit union with whom you already have a working business relationship. Term loans and lines of credit can both be good financing options for small businesses, but they won’t be right for everyone. It is important to consider your business needs and goals when choosing between a term loan and a line of credit.
Term loans are best for business owners when:
- You need to be able to predict your exact repayment schedule over a long period of time
- You don’t have already-owned assets you can borrow against
- You don’t have a credit score or you have a lower credit score
- You do not have an established relationship with a business banker
- You haven’t been in business for very long
- You need a larger amount of capital
Lines of credit are best for business owners when:
- You already have an established relationship with your business banker
- You need variable amounts of money at intermittent times
- You know you will be able to pay back the line of credit in a short period of time
- You need to access money quickly to capitalize on a business opportunity
- You have a valuable asset (like business equity, property value, savings, or personal investment portfolios) that you can borrow against. There are unsecured lines of credit that don’t require collateral, but they are uncommon for personal loans and small businesses.
- You need a lower amount of capital
Term Loan: Pros and Cons
Common examples of term loans are a home mortgage, a car loan, or a small business loan. Some term loans are secured by assets that you already own, meaning that your lender has a right to that asset if you’re unable to repay the loan. Term loans can also be unsecured, meaning you don’t have to put up any assets as collateral. Your ability to access a secured or unsecured loan will depend on several factors, including the amount of the loan, your credit history, and your financial history. When you qualify for a term loan, you will agree to repayment terms for the money you borrow. These terms typically include a down payment amount, a fixed interest rate and initial fees (often expressed as APR), a monthly repayment amount, and the total number of payments or length of the loan. Term loans can be provided by many different kinds of financial institutions including banks, credit unions, community development financial institutions (like Accion Opportunity Fund), and online lenders.
- You know exactly how much you are going to repay and when you are going to pay it.
- If you are choosing between a loan and a line of credit from your business bank, the loan will often have a lower interest rate than the line of credit.
- You can often get larger loan amounts than with a line of credit. Term loan amounts are often tied to the value of the asset you are purchasing, not the value of assets you already own.
- It is possible to get term loans without excellent credit, assets you already own, or a well-established relationship with your business banker.
- Many lenders require you to justify what you are buying with the loan funds and show how it will help your business.
- If you plan to use the loan to purchase equipment or another large asset, your lender or vendor may require a down payment. These funds provided up-front will likely need to come from your own savings and could be as much as 20% of the total cost of the asset.
- You are locked into a long-term contract. You have to make regular loan payments for the entire term of the loan, which could be years or decades.
- It often takes a long time to get approved for a term loan. From the time you submit your application, it can take days or weeks before your financial institution is able to make a decision on your application. This makes it challenging to use a term loan to take advantage of certain business opportunities, like a sale on equipment, or to cover urgent needs, like a payroll shortfall.
- You can only use money from the loan for the specific purpose that was approved in the loan. If you applied for a loan to buy a new oven for your bakery, the loan funds can only be used to buy that oven.
Line of Credit: Pros and Cons
Most people are familiar with a small-scale line of credit in the form of credit cards. As with a credit card, when you have a line of credit, you are pre-approved by your business bank to borrow up to a certain amount of money at any time. When you qualify for a line of credit with your bank, you will agree to repayment terms for the money you borrow. These terms will include the interest rate, credit limit, and any assets or collateral that are tied to the credit line. Unlike most credit cards, you will have to pay interest on any money you draw on (borrow) from your line of credit, regardless of how quickly you pay off the principal amount you borrowed.
- Once your line of credit is established, you can get the money you need when you need it. You don’t have to worry about losing out on a business opportunity because are waiting for your loan application to be processed.
- It can help smooth out your cash flow cycle. Every business has different financial needs. For example, a seasonal business might experience a dip in money coming into the business at certain times of the year. A line of credit can help you continue to operate during these times.
- You’ll develop an even deeper connection with your business banker. This can be hugely beneficial as you continue to grow your business.
- Interest rates are higher than what you can usually get on a term loan from a bank.
- Interest rates can be variable. The interest on your line of credit is usually related to prime (the prevailing interest rate set by the Federal Reserve) and can vary from month to month or week to week.
- You have an indefinite amount of time to repay the principal of the loan. This can be both good and bad. Lines of credit don’t usually have a fixed repayment term for the principal of the amount you borrow. However, you are required to pay interest every month on the money you have borrowed. This is good because you can use the money for as long as you need it. This can be bad because you might pay higher (and variable) interest rates on a large sum of money until you are able to pay back all the money you have borrowed.
- You often must pay a fee every year for your line of credit, even if you don’t use it.
- The limit of your line of credit is based on a fixed percentage of assets that you own. Your credit limit is tied to the value of those assets, so you cannot sell those assets and still maintain the line of credit.
Beware of Predatory Lenders
According to Debt.org, “Predatory lending is any lending practice that imposes unfair or abusive loan terms on a borrower. It is also any practice that convinces a borrower to accept unfair terms through deceptive, coercive, exploitive, or unscrupulous actions for a loan that a borrower doesn’t need, doesn’t want, or can’t afford.”
When searching for financing for your business, including in the form of term loans and lines of credit, it is essential to evaluate the lender and make sure that its lending options are right for you and your business, just as much as the lender is evaluating you as a borrower. Companies that are not regulated and bound by state treasury laws typically offer loans full of hidden fees and fluctuating payment schedules. These daily or weekly repayment schedules can strip business owners of the cash they need to operate.
When evaluating a financing offer, you want to look for traditional terms such as a monthly payment schedule, easily understandable terms, and APR. When it comes to daily or weekly payments, proceed with extreme caution. Depending on your cash flow, it may be best to avoid such a loan because it can hurt the future of your business.
Lenders that do not clearly share upfront the cost of a loan or who advertise that they’ll give you fast cash without asking for details about your business may have something dangerous to hide. If you are considering a loan, be sure to familiarize yourself with predatory lending practices and techniques to protect your business.
When in doubt, don’t be afraid to ask for a second opinion: Accion Opportunity Fund offers one-on-one business coaching totally free of charge, and a professional business expert can take a look at your financing offer to help you understand the terms and decide what’s right for your business. If you have questions about term loans and lines of credit, our business coaches are here to help!
Financing with Accion Opportunity Fund
If you do decide that a term loan is right for you and your business, consider working with Accion Opportunity Fund. At Accion Opportunity Fund, our goal is not only to help you get the funding and support you need to launch your business, but to help you grow and thrive once you’ve got your foot in the door. Accion Opportunity Fund is a government-regulated, non-profit financial institution with a mission to help small business owners reach their goals. Find out more about our small business loan program and apply online today.
Disclaimer: Average interest rates and typical loan terms can change rapidly, so please thoroughly check with any provider to confirm rates and terms.