Running a business comes with unexpected expenses that knock you off track and costly decisions that can’t wait. For example, your important equipment might break down, or a terribly low sales season may make keeping the lights on difficult. Whatever situation you face, you can access multiple financing solutions to come out of it.
However, the wrong financing choice could leave you trapped in debt and regulatory issues. Therefore, understanding how these products are structured and their best use cases is mandatory: it informs your decisions and ensures you play your cards right.
This article explains how a small business loan differs from a line of credit and when these two solutions make the most sense for your business. Keep reading to choose well.
Key Differences Between a Small Business Loan and a Line of Credit
Business financing can boost your success or complicate your balance sheets without a real benefit. That’s why smart business owners thoroughly compare different products to play safe. That said, here are the main things that set a small business loan apart from a revolving line of credit:
Funding Structure
A business loan is exactly what its name indicates: a loan amount you receive as a lump sum. In other words, if you borrow $50k for your business needs, you receive the entire amount in your account. Then, you repay it in installments per your agreement and can use it for whatever business needs.
However, a business line of credit works differently (but quite similarly to your personal credit card). If you qualify for it, you get access to a set credit limit (such as $50k if we continue the same example), and you draw from it on an as-needed basis. Put simply, you don’t receive a lump sum and repay only what’s used. For example, you might draw $10,000 a month, even if $50k is made available to you. But since your current requirement isn’t as big, you choose what to take from your credit.
Repayment Terms
The next major difference between these two products is the repayment structure. With small business loans, the repayment is fixed and follows a schedule, i.e., monthly repayments spread across 5 years. As a result, the amount you owe the lender each month doesn’t change and can’t be ignored either.
On the other hand, a line of credit does not work on a fixed schedule, and you repay based on what you draw. Also, once you repay the used amount, that credit becomes available to you again, which is called a revolving structure. So if your credit limit is $30,000 and you repay $10,000, you have $30,000 available again.
Interest Rate
The loan interest rate is calculated as a percentage of what you owe, as a cost you pay to borrow money. When you take a business loan, the interest is naturally charged on the full amount from the beginning. Luckily, these rates are not obnoxiously high in most cases because lenders know the exact amount they’re lending.
That said, a line of credit has a higher interest because it’s unpredictable how much you’ll draw in a given month. But since you only pay interest on the amount you draw and not the full credit limit, you can control it. Putting that into numbers, if you have a $40,000 line and use $8,000, you only pay interest on $8,000.
Access to Funds
A small business loan is a one-time transaction: you get approved, receive the money, and that’s it. In case you need more capital later, you have to apply again, which will take time and test your patience.
In this aspect, a line of credit differs because it stays open and accessible throughout its term. You can draw funds, repay them, and draw again repeatedly, without going through a new application each time. This surely is a significant practical difference for business owners.
In short, a loan works well when you know what you need and when you need it, but a line of credit works better when your funding needs are ongoing or unpredictable.
Collateral Requirements
Collateral is an asset that you pledge to a lender as security against the loan, such as your property, equipment, or inventory. In case you can’t repay the loan and default, the lender can seize that asset to recover their money. That said, business loans typically require collateral because lenders want security when they hand over a large fixed sum.
However, lines of credit can be either secured or unsecured. For instance, if it’s a smaller credit line, it likely won’t require collateral, which makes these lines more accessible for businesses without major assets. But larger lines may still require it.
Best Use Cases of a Loan and a Line of Credit
Your business could face tons of situations when the money is tight, and you need a cash injection. Here are some of those situations and the financing solution that makes more sense for them:
Line of Credit
- Paying the staff during a slow season
- Managing cash flow gaps when client payments are pending
- Unexpected equipment repairs
- Urgent restocking when inventory runs low
- Keeping operations running during a slow month
- Grabbing a short-term supplier discount when cash is tight
Small Business Loan
- Purchasing equipment or machinery with a known price tag
- Renovating or expanding a physical location
- Launching a new product line that needs upfront investment
- Acquiring another business or buying out a partner
- Hiring a large batch of staff for a planned expansion
Conclusion
Both loans and lines of credit can give you a hand when the money is tight, and you don’t want the business to face the aftermath. But the one you opt for depends on your current financials and the purpose you’ll use this money for. So, plan it strategically by talking to ROK Financial experts and make sure this funding serves the purpose right.
FAQs
Can I have both a small business loan and a line of credit at the same time?
Yes, that can happen. Many business owners use both together. They might use a loan to cover large planned expenses, and a line of credit handles day-to-day cash needs. So as long as your financials support both, there is no rule against holding them at the same time.
Is a line of credit harder to get than a loan?
Generally, no. A line of credit is usually easier to qualify for, especially if the limits are smaller. Loans require more documentation and a clear purpose for the funds. That said, larger credit lines can be just as competitive as loans. So it all depends on the amount and the lender.
What can a startup qualify for more easily? A line of credit or a business loan?
Practically, neither is easy for a startup, but a small line of credit can be more accessible. Lenders see startups as higher risk, and since a line of credit at a lower limit requires less proof of track record, it’s easier to get approved for. On the other hand, a loan is harder because lenders want a stable revenue history before committing a lump sum.