Every financial decision for your business is important. Especially if you are thinking of taking on financing, it’s essential that you know with some real certainty that you are getting the right product for your needs. Many small business owners likely find themselves stuck between two popular choices, those being business loans and business lines of credit. While both types of financing have their benefits, it’s more than possible that one may suit your needs better than the other. Let’s get into the key differences between a business loan and a line credit.
What is a Business Loan?
A business loan is basically an agreement between a lender and a borrower in which the lender gives a one-time lump sum of money to a borrower. The borrower is then responsible for paying back that lump sum to the lender with interest. What we’re describing here is also called a term loan, a loan that you pay back over a certain term.
Depending on the lender and the merits of a borrower, business loans can be for amounts up to $5 million and be as long term as 25 years. But the important thing to remember when it comes to business loans is that they generally only account for one singular sum of capital. When you pay back a loan, you can of course take out another one. But business loans are almost always one-time, lump sum transactions.
Business Loan Benefits
Business loans come with specific benefits, including:
- Set Repayments: Business loans usually have a fixed rate, which means fixed monthly payments throughout the life of the loan. This makes it easy to budget for repayments.
- Relatively Lower Interest Rates: Generally speaking, business loans have a lower interest rate than business lines of credit. However, rates depend entirely on your credit history and financials.
- More Financing Term Options: Business loans can provide both long- and short-term financing, making them suitable for large investments or smaller expenses..
Business Loan Drawbacks
There are reasons that some business owners choose a business line of credit over a loan. Drawbacks to a business loan include:
- Collateral Requirement: If you’re applying for a secured business loan, you’ll be required to put up collateral for the loan.
- Application Process: The application process for business loans can be more complex than other forms of financing, such as lines of credit or credit cards. However, this can vary form lender to lender.
- Fixed Funding Amount: If you find that you need more funds than you received from the loan, then you’ll need to apply for additional financing.
Business Loan Requirements
When applying for a business loan, there are some almost universal requirements that lenders will need to see before approving you. Let’s get into the most universal of those requirements here.
A Specific Purpose for Your Business Loan: Lenders will want to know what you plan on using your capital for. Business loans, however, don’t have to be used to buy one specific thing. While many people use term loans to secure real estate or other expensive assets for their business, it is more than viable to say that you plan on using your business loan to increase your working capital.
Collateral: Just about all business loans today will require some form of collateral. There are, of course, always exceptions. But it is a good idea to anticipate your lender asking for collateral if you are looking for a business loan. Good examples of collateral include real estate, heavy equipment, or even standing inventory. Basically, collateral can be any business asset of close-to-equivalent value of the loan you are looking for.
Required Documents: Every lender will require some amount of paperwork from a borrower before moving forward on a loan. Having PDF copies of all of these forms before applying will likely save you some time later in the process.
- Your most recent business bank statements
- Your most recent tax returns
- Forms on ownership and affiliation if necessary
- Proof of your collateral
- Disclosures of other debt
- Your driver’s license or other valid state ID
- Any documents related to a reincorporation or business name change
- Any business insurance polices you currently hold
Time in Business: The longer your business has been in operation, the better you will look to lenders, generally speaking. It’s not uncommon for lenders to ask for at least two years of operation for business loans.
Business Plan: While not universally required, it’s more than possible that some lenders may expect you to present a business plan that includes (among other things) what you plan on using your business loan for. Your business plan ought to be a comprehensive overview of your current structure and how you plan to grow or change over at least the next five years. The more involved and specific your plan is, the more trustworthy and responsible you are likely to appear to lenders.
What is a Business Line of Credit?
A business line of credit is essentially a supply of capital provided by a lender that you can draw and repay as long as the line stays open. Similar to traditional credit cards, lines of credit have a credit limit, often have monthly billing periods, and borrowers are only responsible for money that isn’t paid back into the credit line before the end of a billing period. But unlike credit cards, which can only be used for transactions that allow card payment, lines of credit are real working capital that businesses can use to cover traditional expenses like payroll or even inventory costs.
Business Line of Credit Benefits
Business owners may prefer to select a business line of credit over a loan due to the following benefits:
- Flexibility: A business line of credit provides flexibility in accessing funds. You can borrow as much or as little as you need up to your credit limit, making it ideal for businesses that might need additional funds down the road.
- Interest Only on What You Use: While a term loan charges interest on the entire loan amount, a business line of credit only charges interest on the amount you draw. This could
- Different Payment Options: Some business lines of credit let you choose how often you want to repay, whether that be every week or every month. This gives small businesses even more flexibility.
Business Line of Credit Drawbacks
Drawbacks of a business line of credit include:
- Variable Interest Rates: The interest rates on a business line of credit are often variable, meaning they can fluctuate with market conditions. This variability can make it challenging to predict future repayments.
- Potential for Overborrowing: When not managed correctly, a business line of credit makes it easy to accidentally borrow more than you’re eligible for. Always keep an eye on the total line of credit and the amount drawn.
- Collateral Requirements: Just like a term loan, some lenders may require collateral, such as business assets or personal guarantees, to secure a line of credit. This adds a layer of risk, as failure to repay could result in the loss of assets or personal liabilities.
Business Line of Credit Requirements
Every lender has their own requirements and makes agreements on a case by case basis. But when applying for a line of credit, there are some basic things that just about every lender will be looking for. Let’s get into those major requirements here. But it is important to remember, also, that some lenders may require more and there are likely more than a few who could ask for less.
Incorporated Business: While there are certainly some online lenders willing to give lines of credit to sole proprietors, the majority of todays lenders are looking for incorporated (as well as registered) businesses.
Use of Funds: The majority of lenders, especially for larger lines, will be looking for a proposal that lays out your general intentions. Unlike a business plan which explains your overall aspirations and plans for growth, your proposal ought to be solely centered on how you plan on using your line of credit.
Collateral: There are two distinct types of lines of credit, one which requires collateral and one which does not. A secured line of credit is a line of credit that is secured with collateral from the borrower. An unsecured line of credit is a line with no collateral. As you may guess, a line of credit with no collateral represents a higher risk factor for lenders and therefore often comes with a higher interest rate. Further, the majority of larger financial institutions like banks and credit unions who offer lines of credit generally offer secured lines. This means that if you don’t have the sufficient collateral to secure a line, you may want to look into online lender options.
Required Documents: Lines of credit require many of the same documents as a business loan.
- Your most recent business bank statements
- Your most recent tax returns
- Disclosures of other debt
- Your driver’s license or other valid state ID
- Forms on ownership and affiliation if necessary
- Proof of your collateral (If you are seeking a secured line)
- Your loan proposal
- Any documents related to a reincorporation or business name change
- Any business insurance polices you currently hold
Time in Business: It is likely that larger financial institutions will be looking for potential borrowers who have been in operation for at least two to three years. It’s possible to find online lenders asking for less but, as the rule goes, the younger and less proven a business is, the more likely interest rates will go up.
Industry: Unlike many business loans, which are anything but industry specific, some lenders may shy away from certain industries when it comes to lines of credit. The industries that get considered ‘risky’ are decided by the risk departments at each individual lender but here are some of the industries that tend to be classed as high risk and, therefore, may have more trouble securing a line of credit:
- Restaurants / Food industry
- Retail
- Wholesaling
- New or used car dealers
- Casinos (excluding hotels)
While this doesn’t represent every high-risk industry, this list represents businesses that are more sensitive to economic cycles, deal mostly in cash, or are subject to a large amount of legal regulation.
Choosing Between a Business Loan vs Line of Credit
Where to Get a Business Loan or Line of Credit
There are three major ways to connect your business with a loan or a line of credit. Let’s explore them each, one by one, to better understand what makes one a better match for a business compared to another.
Banks
With some exceptions, securing a line of credit or a loan with a major bank requires the most paperwork. On top of that, banks often have the highest requirements for credit scores as well as revenue and time in business. What you get in exchange for those higher requirements, however, are more generous term and interest rates.
Online Lenders
Online lenders represent the quick and flexible alternative to the traditional bank option. Online lenders have grown in popularity over the past generation and become a lifeline for younger businesses thanks to both their generally more lenient requirements as well as the speed in which lines can be opened and loans can be distributed. What you get in exchange for that speed and lower scrutiny is, of course, more cautious interest rates and terms.
Community Development Financial Institutions
Community Development Financial Institutions (CDFI) are groups that specifically serve under-resourced communities. If you are a business owner in a rural area or are a member of a special interest group, there is a good chance that there is a CDFI who may be interested in working with you.
Choosing the Right Financing for Your Business
While business loans and lines of credit both provide working capital for your business, the way you access that capital is completely different. Business loans are usually a good match for large one-time purchases like real estate. Since your capital is coming in as one lump sum, it generally makes the most sense to spend it in the same way. A line of credit, however, is a longer-term relationship between a lender and borrower. It is more than possible for a line of credit to stay open for a couple of years.
A line of credit, then, should be used for predictable and repeatable expenses that you are certain you can pay back before the end of a billing period so you can avoid interest. Businesses who handle lots of invoices or who only see payouts once or twice a month are the most likely to benefit from the type of working capital that a line of credit can supply.
