Loans and lines of credit are the most popular business financing options today. According to The Federal Reserve Bank’s 2022 Small Business Credit Report, 76% of the surveyed firms sought out loans and lines of credit in the last 12 months. The application rate for business loans was slightly higher at 43%, while that for lines of credit came in at 31%.
However, loans and lines of credit are two distinct forms of business financing. They are structured differently, and each option is suited to a particular funding scenario. So, how is a loan different from a line of credit, and more importantly, which of the two is the better financing product?
Let’s take a closer look at the distinctions between business loans and lines of credit, their pros and cons, and ideal use cases:
What is a business loan?
A business loan, also known as a commercial loan, is a financing solution whereby the lender extends a lump sum amount, which the borrower must repay, with interest, in the agreed period (or “term”) and manner. In this context, we’re referring to term loans. These are usually structured in flat, amortized monthly repayments with either a fixed or floating interest rate expressed as Annual Percentage Rate (APR).
You can get business loans from various lenders, including commercial banks, the Small Business Administration (SBA), peer-to-peer lending sites, and direct online lenders. Keep in mind that each lender has their own loan qualification requirements, although you generally need to tick these boxes to qualify for most term loans:
- Strong business credit
- High-value collateral and/or personal guarantee (for secured business loans)
- Healthy cash flow
- Solid business plan
- Long business history (at least two years)
- Low levels of debt utilization
- Valid reasons for borrowing
The pros and cons of business loans
Here are the main upsides and limitations of term loans as a business financing solution, compared to lines of credit:
The pros:
- You can borrow quite a lot of money through loans. For instance, SBA’s Standard 7(A) loans go up to $5 million.
- The funds are usually disbursed in one upfront payment, ideal for bridging huge financial gaps.
- Loans are very versatile. They can be used to fund just about any large or small financial need, from working capital and equipment purchases to disaster recovery.
The cons:
- It can be tough for SMBs and start-ups to qualify for a business loan, especially from large banks and institutional lenders.
- You might not get the exact amount you want from one loan, which could mean taking multiple loans from different lenders to meet your goal.
- The loan rates and costs can sometimes be too high, particularly for those businesses that lenders deem high-risk borrowers.
What is a business line of credit?
A line of credit (LOC) works like a credit card. In fact, a business credit card is a good example of a commercial LOC. It's a ready pool of funds you can access and draw at any time during a given window known as the draw period. This window typically lasts 6 to 24 months but can sometimes stretch to 5 years.
Like with a credit card, you can only draw funds up to a certain borrowing limit. And you must pay off the withdrawn amount (plus interest) by a fixed date. Only the withdrawn amount accrues interest, which is often calculated as APR. But in addition to the interest, some lenders charge a small fee for every withdrawal, usually between 1% and 3% of the amount. The lender may also charge inactivity fees if the LOC goes dormant for some time.
Revolving vs. non-revolving credit
Most LOCs are structured as revolving funding accounts, meaning that the cash reserve is replenished after every repayment made during the draw period. With a revolving or open-end LOC, you can borrow money, repay it, and borrow again in virtually endless cycles.
On the other hand, a non-revolving or closed-end credit does not replenish the funding pool after repayment. Once you hit your borrowing limit, that’s it. You can only repay the debt and re-apply or get a new line of credit if you need more money.
Pros and cons of lines of credit
How does a line of credit compare to a term loan in terms of benefits and drawbacks?
The pros:
- Most businesses find it easier to qualify for a line of credit than a term loan since LOC requirements are not as strict.
- You only pay interest on the amount drawn from the credit pool, which helps optimize borrowing and debt utilization costs.
- A LOC is a reassuring financial cushion for short-term needs such as smoothening cash flow dips, settling seasonal or unexpected expenses, and recovering from disasters.
The cons:
- Generally, lines of credit have much lower limits than conventional loans.
- The extra draw, inactivity, and repayment costs can really add up, making it an expensive borrowing option.
- A revolving line of credit can encourage a costly borrowing habit that leaves the business in a perpetual debt cycle. This is a common problem, even with personal credit cards.
Deciding between a loan and a line of credit
So, which is better, a loan or a line of credit? Choosing between the two is not really a question of which is better. Each option has unique features, merits, and limitations that make it suitable for particular financing situations. You must determine the approach that better fits your funding needs and qualification status.
When to take a loan
Term loans are designed mainly to fund heavy one-off investments such as buying equipment and property, expansion ventures, or batch stocking supplies. Loans can also be used to take advantage of new business opportunities or refinance other debts. Basically, a loan is ideal for financial needs requiring lump sum cash injections.
When to take a line of credit
A business line of credit suits short-term financial needs and ongoing operating expenses. It fills moderate financial gaps such as unexpected expenses, payroll, petty cash, bills, and temporary cash flow shortages. Additionally, many business owners take out a line of credit as a stand-by emergency stash or financial cushion.
Summary
Here’s a condensed summary of the key differences between business loans and lines of credit:
Explore business loans and lines of credit with Lendzero
The loan vs. line of credit battle boils down to preference, potential value, and practicality. But before settling for either financing, it's best to weigh all your options first. Compare multiple loan and LOC offers from different lenders to find the most suitable deals in terms of economy, flexibility, terms, and other merits. And how better to do this than with Lendzero?
Lendzero helps you explore and compare dozens of financing options from multiple lenders by presenting you with all the offers available to your business. Also, every offer comes pre-negotiated in your favor. This single platform saves you all the time and energy you’d otherwise waste scouring the internet for financing deals and haggling with lenders. Start with Lendzero for free and access easy business financing — loans, lines of credit, and more.
