Line of Credit vs. Loan: Making the Right Choice for Your Business
When it comes to business financing, there are a few options available to small business owners. Two of the most common choices are business lines of credit and loans. Both options offer distinct features, benefits, and drawbacks depending on your business needs.
While both a business line of credit and a loan serve as valuable financial tools, they differ significantly in their structure, flexibility, and usage. This article aims to provide a comprehensive comparison of a business line of credit vs. loan to help you figure out which one is best for your small business.
What Is a Loan?
A loan is a lump sum of money that is borrowed from a lender, such as a bank or credit union, with the understanding that the borrower will pay back the loan amount and pay interest on it.
There are different types of loans including:
Personal loans: Personal loans are a lump sum given to individuals to help them pay for big-purchase items, such as engagement rings, home improvement, or debt consolidation. They often have lower interest rates than a credit card.
Business loans: A business loan is a type of loan given exclusively for business purposes. That can include buying inventory, updating machinery, or helping cover operation costs.
Mortgages: When someone wants to purchase a home, they usually receive a special loan known as a mortgage, which is secured by the real estate being purchased.
Student loans: Student loans are common loans used to fund education expenses. These types of loans are issued through federal or private lending programs.
While the specifics of each loan type might vary, they all tend to share similar characteristics. For example, loans usually have a repayment plan that includes fixed monthly payments. Loans are issued for specific purposes, such as expanding a business, buying a home, or funding education. The total cost of borrowing is known upfront, including the period of time it will take to repay the loan and the interest rate.
Benefits and Drawbacks of Business Loans
If you have a large one-time expense or purchase, such as an expansion project, a real estate purchase, or equipment to replace, a business loan can help you cover the cost in the short term and pay it back over time. A business has a structured payment plan, so you know exactly what it will cost over time and can budget for it.
Another benefit is if you take out a secured loan, one backed by collateral, you can often get a lower interest rate than other types of business financing.
However, there is also less flexibility when it comes to loans. Once a loan amount is borrowed, it can’t be accessed again without applying for a new loan. So for businesses that have ongoing funding needs, a one-time loan might not be the best financing solution.
Plus, if you do take a secured loan to save on interest, there is risk involved. If you’re unable to pay back your loan, the lender can take possession of your collateral.
What Is a Line of Credit?
A line of credit is a type of credit account. With a line of credit, a financial institution, such as a bank or online lender, advances credit to the borrower. This can be used repeatedly, making it a revolving credit limit. Credit lines can be used for a variety of purposes instead of being just limited to one type of purchase, like loans often are.
A line of credit works very similarly to a credit card. Small businesses or individuals can get access to the funds they need as long as there is still credit available. In some cases, you can make a purchase with a debit card that is linked to a line of credit account.
Let’s look at an example of a line of credit works. If you have a line of credit for $50,000 with a $20,000 balance, that means you have borrowed $20,000 and can still use up to $30,000. If you pay off the $20,000, then you’ll have the full $50,000 line of credit available to use.
There are a few types of lines of credit including:
Home equity line of credit: Also known as a HELOC, this line of credit is secured against your home, which gives you a revolving credit to use for large purchases. HELOCs normally have variable rates.
Business line of credit: A business line of credit is a revolving credit line that can be used by companies when they need it. Depending on how much credit is requested, it can be secured or unsecured. Business lines of credit may have fixed or variable interest rates.
Personal line of credit: A personal line of credit is similar to a credit card. An individual can borrow money and pay it back as they need it. A personal line of credit usually requires a higher credit score than other types of financing and often comes with higher interest rates than loans.
Benefits and Drawbacks of a Business Line of Credit
One of the benefits of a business line of credit is that interest only accumulates when you use the credit. Let’s say you have a line of credit for $25,000, but you only end up needing $15,000. You’ll only have to pay interest on the $15,000 you borrow. This is different from a loan. If you took out $25,000, but really only ended up needing $15,000, you’d still have to pay interest on the full amount.
It also offers a lot of flexibility, as the funds can be borrowed when needed. This makes it ideal for small businesses with seasonal expenses or capital fluctuations. With a business line of credit, you can make minimum monthly payments and increase your payments based on your cash flow, helping you manage your finances.
However, a line of credit often has higher interest rates than loans. It also requires financial discipline to avoid overborrowing and accumulating unnecessary debt.
Business Line of Credit vs. Loan: How to Choose?
When it comes to choosing a business line of credit vs. a loan, you want to think about what you need the financing for, the flexibility you need, how interest is charged, and the repayment terms.
You’ll want to ask yourself the following questions. Do I have a large one-time purchase to make, or do I need to cover a cash flow gap? Do I know the exact amount of money I need to borrow? Will I be able to pay back the funds I borrow in the short term, or do I need to spread out the cost over a longer time frame? In the first case, you have a set amount of money you need in order to make your purchase. In the second case, you may need more flexibility in how much you need to borrow and when.
For example, let’s say you have a retail business and need to buy some new displays, signage, and checkout equipment for the store. It’s a one-time purchase that you hope will last you for many years. You know exactly how much money you need for the purchases, and you’d like to pay for the expense over the next five years. In that case, a loan would be a better choice.
But let’s say your retail store needs to hire extra workers for the holiday rush, but you won’t have the funds to pay them until your holiday sale revenue starts coming in. The amount you need isn’t exact because it will depend on your current cash flow come pay day. In that case, a line of credit would be a better option because you have extra flexibility and you’ll be able to pay back the money you borrow once your sales come in.
Another thing to note when deciding between the two is that a line of credit may be difficult to obtain if you need to improve your business credit score, while loans offer more options if you don’t have a great credit history.
Get the Financing Your Business Needs
There are many things to consider when it comes to business line of credit vs. loan options. Loans are a lump sum of money lent by banks and other financial institutions. They are often used for major purchases and help you spread out of the cost over a longer period of time.
A line of credit, on the other hand, is often used for businesses that need ongoing access to funds for unexpected short-term expenses or cash flow gaps. A line of credit offers a lot more flexibility, especially for seasonal businesses.
Backd has two flexible financing options for you. You can get a business line of credit with unlimited terms and competitive rates. Credit amounts range from $50,000 to $750,000. And when you apply, Backd does a soft credit pull, meaning your credit is checked but does not impact your credit score.
And if you need a lump sum to invest in equipment or bridge a cash flow gap, Backd also offers a working capital advance of up to $2 million with no collateral required. You can get up to 16-month term lengths and flexible repayment schedules.
Apply today for the funding that’s right for you.