The Difference Between Lines of Credit and Term Loans
When it comes to financing business operations, the available options generally fall into one of two categories: term loans and lines of credit. Deciding which is right for your business requires an understanding of the primary differences between them. These two financing options differ in several significant ways, including when repayment begins, the cost of borrowing, what it takes to qualify and when one is preferable to the other.
Term loans spell out the payment schedule for the duration of the agreement. Monthly payments will include principal and interest and be due on a specific date. Your first payment on a term loan is payable, whether you have used the money yet or not. With a credit line, on the other hand, no payment is due until you have taken a draw on the line. Then, monthly interest payments will be due until the principal balance is paid in full, and unlike a term loan, there is no early payment penalty.
Cost of Borrowing
As the name suggests, a term loan has a specific start and end date, and it typically has a fixed interest rate. The interest rate and closing costs are usually higher for a term loan than for a line of credit. Term loans may also have prepayment penalties to offset the lost interest income on loans paid off early. While a line of credit typically has a lower interest rate and closing costs, the rate could fluctuate based on the current prime interest rate, which adds some uncertainty.
A line of credit is usually easier to qualify for than a term loan, making it a good option for businesses just starting out or those with a lower credit rating. Generally speaking, to be eligible for a term loan, your business must have a strong credit rating and have been operating for at least three years. Credit lines generally require only one year of operations.
A term loan is the best option for specific, one-time purchases such as new equipment or to open an additional office. Lines of credit are best used for ongoing operating capital to compensate for the timing of accounts receivable collections or other cash flow constraints.
Financing can be a critical factor in operating a successful business. Term loans and credit lines serve different purposes, differ in their repayment structures and vary in cost. Term loans are best for one-time purchases or investments, while credit lines are beneficial for cash flow management for regular operations. Knowing which to choose is easy once you understand the differences.