Business Line of Credit vs. Term Loan: Which One Fits?

A term loan gives you a lump sum up front. You repay it on a set schedule, usually monthly, over a fixed period. The period might be a few months for some online loans or several years for bank and SBA loans.

Because you get all the money at once and start paying interest on the full amount right away, a term loan fits best when you know exactly what you need and when you need it.

• Good for one-time purchases like equipment, a vehicle, a renovation, or buying another business.
• Predictable payments make budgeting easier.
• You pay interest on the whole amount from day one, even if you do not spend it right away.

A line of credit gives you access to a set limit that you can draw from as needed. You pay interest only on the amount you actually use. As you repay what you drew, that amount becomes available again, much like a credit card.

Lines of credit are built for flexibility. They work well for costs that come and go, or for smoothing out the gap between paying your bills and getting paid by customers.

• Good for working capital, seasonal inventory, payroll during slow months, or unexpected expenses.
• You only pay for what you use.
• Some lines charge annual or draw fees, and rates can be variable.
• Lenders may review the line periodically and can reduce or close it if your business changes.

Ask yourself whether the need is one-time or ongoing. If you are buying something specific that will serve the business for years, a term loan usually matches the need better. If your need rises and falls, or you want a safety net you may or may not use, a line of credit usually fits better.

Some businesses use both: a term loan for a major purchase and a line of credit for day-to-day cash flow.

Both products usually depend on your revenue, credit, and time in business. That said, there are some differences worth knowing.

For term loans, lenders often focus on whether your cash flow can support a fixed payment over the full term. Larger, longer loans from banks and the SBA usually require more documentation, stronger credit, and a longer operating history.

For lines of credit, lenders often look closely at the consistency of your revenue, because they are committing to let you borrow again and again. Some lines are secured by receivables or inventory, which can make them easier to get if your credit is middling.

For a term loan, compare the interest rate or annual percentage rate, origination fees, the term length, and any prepayment penalty. A lower payment spread over more years can cost more in total interest.

For a line of credit, compare the rate on drawn funds, whether it is fixed or variable, any annual maintenance fee, any fee each time you draw, and how long you have to repay each draw. Some short-term lines require each draw to be repaid within months, which behaves more like a series of short loans.

• Using a short-term product to pay for a long-term asset, which creates large payments before the asset has paid for itself.
• Taking a large term loan for flexible needs and paying interest on money sitting idle.
• Treating a line of credit as permanent capital and staying maxed out, which can make lenders nervous at review time.
• Not reading how the lender can change or close a line of credit.

Match the product to the need. Term loans suit defined, one-time investments. Lines of credit suit ongoing or unpredictable expenses. Whichever you choose, compare the total cost across a few lenders and make sure the payment fits comfortably inside your monthly cash flow.