Business loans and lines of credit (LOCs) are valuable sources of capital for your small business. Both offer access to funds that can help your company get going, or get bigger. Either may do away with the need to approach independent investors.
So, which one is right for your business?
Choosing Between a Loan and a Line of Credit
There are some key differences between a loan and an LOC that help determine which is the best choice, and when. The most important of these is that while a business loan serves a one-time purpose, a line of credit can be used repeatedly.
A line of credit can keep your operations flexible and provide general support for the growth of your business. It’s also great for tiding you over during the occasional monetary emergency. You could think of an LOC as preventative financing – something you set in motion before you actually need it. A business loan, by comparison, is something you would normally only consider for a very specific purpose.
Among other things, loans from banks and lenders like the US Small Business Administration are commonly used to fund:
- large inventory orders,
- new or used equipment and machinery, and
- the remodeling or expansion of business facilities, including the purchase of real estate
A business line of credit, on the other hand, is a great temporary financing tool. Its versatility and ongoing availability make it ideal for:
- helping to negotiate the best deals with suppliers,
- ensuring crucial expenses like payroll are always covered, and
- gaining a competitive toehold with the ability to respond quickly to customer demands
But beyond their individual purposes, cost is another factor that sets business loans and lines of credit apart.
Why a Line of Credit May Be Right for Your Business
A line of credit is often the cashflow-friendly alternative to a full-blown loan. While many business loans come with a fixed rate of interest, most LOC interest rates are lower and variable. That’s a built-in advantage for business owners who manage their credit effectively. So long as you stay within your established credit limit - and make your payments on time – you’ll pay less, and won’t have to wonder if it would have been cheaper to apply for a loan in the first place.
The monthly cost associated with supporting a business loan is typically greater than that of an LOC because:
- most loan payments begin immediately,
- interest rates are generally higher, and
- payments must be made every month
These rules hold true whether you’re actively using your loan funds or they’re just taking up space in your account.
With a line of credit, on the other hand, you only pay interest on the money you use – or draw down - each month. You never pay interest on funds you don’t access, so when your borrowed balance is zero, so are your payments. In most cases, you can repay as much or as little of the original LOC principal as you like. And once those amounts are repaid, they become available to use again. In that sense, a line of credit is like a virtual loan-on-demand!
A business loan is a long-term debt that can take multiple years to pay off, but an LOC is a ready source of short-term financing. It even offers certain advantages over a business credit card. While both charge for funds only when they’re accessed, a line of credit features:
- interest rates that are much lower,
- revolving credit terms, and
- minimal, if any, administrative fees
Small business loans are notorious for adding extra expense to a debt through miscellaneous fees known as closing costs.
Making the Most of Your Borrowed Funds
Does this make a business line of credit the better choice in every situation? Not necessarily. In fact, you should be aware that some lending institutions set restrictions on how LOC funds can be used. Others may require that outstanding amounts be repaid in full at various intervals – just to reassure themselves that your company’s still active and solvent.
There’s also the chance that a business owner will squander their line of credit on too many unplanned events. Working with a financial consultant to establish – and maintain - a viable business plan is one of the best ways to avoid this.
Borrowed funds cover a lot of small business bases. But the most profitable way to benefit from loans and LOCs is to use them for revenue generating activities. This includes marketing programs and other pursuits that contribute directly to your company’s income. In many cases, the growth in sales and clientele that result from an infusion of capital more than offsets any debt.