When you own a small business, finding the right kind of financing can be key to growth. While there are several options available, business loans and business lines of credit are two of the most common. But before you decide to choose one over the other, you should understand the differences between the two as well as the advantages and disadvantages of each.
1. Renewals. Business loans don't renew at the end of the terms. You use your business loan once, while a line of credit is revolving. You can use it multiple times.
2. Timing. “When” you apply for a loan and a line of credit are different. A loan is something you get when you need it, and for one specific purpose. In contrast, a line of credit is usually set up before you need it and, unlike a loan, it can serve multiple purposes.
3. Monthly payments. With a loan, your monthly payment begins immediately and doesn't change from month to month, whether you're using all the money or not. With a line of credit, your payments only reflect the amount of money you've borrowed. If you carry a zero balance, you won't have a payment.
4. Closing costs. These are often lower for a line of credit than a loan. While there are exceptions, the closing costs for most loans (may include processing, credit and appraisal fees) range anywhere from 2% to 7%. The closing costs for lines of credit (may include processing and transaction or withdrawal fees) are generally minimal, if any.
5. Terms or repayment periods. These are fixed on a loan. Because the terms are fixed, the monthly payments are usually higher when compared to lines of credit. As an example, the monthly payment on a $50,000 loan can be $400–700 per month, more than on a $50,000 line or lines of credit.
6. Long-term vs. short-term. Loans are usually paid off in 2 to 6 years. Lines of credit, on the other hand, solve short-term needs. Lines of credit help finance account receivables as well as marketing and payroll needs. They're also useful for unexpected cash-flow shortages.
7. Interest rates. With a business loan, you're likely to have higher interest rates that are fixed, whereas a line of credit may offer lower variable rates. Keep in mind, with a line of credit, if you're late on a payment or exceed your credit line, your interest rates will increase. Conversely, when you manage your line of credit more wisely, you may be able to actually lower your rate.
With different financing options available, it can be difficult to choose the right one for your business. But knowing the difference between two of the most common small business financing solutions can help paint a bigger picture of what your business might need in both the short- and long-term and ultimately empower you to make the money work to grow your business.
Eric Newberry is a business loan expert at Lendio, a free online service that matches business owners with more than 3,000 loan options across the country. Download Lendio's free eBook, “12 Best Ways to Get Business Financing in 2012.” For more information or to use their free online service, click here.