Term loans and lines of credit are two different ways small businesses can borrow capital from lenders. However, they operate differently and serve distinct purposes. Here’s a breakdown to help you decide which might be the best fit for your business.
What is a Term Loan?
A term loan provides a lump sum of money upfront, which you repay over a set period with fixed or variable interest. This is a more structured financing option compared to a line of credit.
The lender determines loan amounts based on the borrower’s needs, income, ability to repay and creditworthiness. Loans are either secured or unsecured. You secure a loan by offering collateral, assets that the lender can seize the collateral to recover their money if you fail to default on the loan.
An unsecured loan does not require any collateral.
For small business owners, the SBA 7(a) is an excellent financing option. This government-backed loan specifically helps small businesses by offering long-term repayment options and low interest rates. Structured as a traditional term loan, it provides a lump sum upfront, which you repay in installments over the loan term.
What is a Line of Credit?
A line of credit is a revolving credit arrangement that allows you to borrow up to a certain limit as needed. You only pay interest on the amount you use, not the entire credit limit, but sometimes you are required to pay a fee on the unused amount as well. This makes it ideal for managing cash flow or covering unexpected expenses. Lines of credit are often renewed annually and can be reused as long as you don’t exceed your credit limit and meet repayment terms.
Lines of credit generally come with higher interest rates compared to term loans. They also tend to impact consumer credit reports and scores more quickly and significantly. To better understand how a line of credit works, think of it as similar to a business credit card. You’re given a credit limit that replenishes as you pay down the balance, covering both the principal and interest.
Feature | Term Loans | Lines of Credit |
|---|---|---|
Borrowing | Lump sum upfront | Borrow as needed, up to a limit |
Repayment | Fixed Installments over time, but will fluctuate if variable interest loan | Flexible; only repay only what you use |
Interest | Lower interest rates. Charged on outstanding loan amount | Higher interest rates. Interest accrues only on the amount drawn, but sometimes a fee is payable on the unused amount. |
Purpose | Long term growth | Short term needs |
When a Term Loan is Better Than a Line of Credit for Small Businesses
A term loan is the better choice when your small business needs a large amount of funds for major growth projects. Situations where a term loan is advantageous include:
- Expansion Projects: Renovating a location, buying new types of inventories, extending service offerings, or large-scale marketing campaigns.
- Predictable Costs: If you prefer fixed repayment terms, which can help with long-term budgeting.
- Lower Interest Rates: If you qualify for a lower rate, especially with secured term loans or government-backed options like SBA 7(a) loans.
When a Line of Credit is Better Than a Term Loan for Small Businesses
A line of credit is ideal for small businesses that need flexible, short-term access to funds to manage cash flow. It works best in scenarios such as:
- Covering Cash Flow Gaps: Managing seasonal revenue fluctuations or waiting on unpaid invoices.
- Unexpected Expenses: Handling emergency repairs or last-minute supply orders.
- Interest Savings: Borrowing only what you need, when you need it, so you pay interest solely on the amount used.
Bottom Line
Both term loans and lines of credit can be valuable tools for small business owners, but the best option depends on your unique circumstances. Carefully assess your financial needs, repayment capabilities, and long-term goals. For many businesses, a combination of the two may provide the balance needed to grow and thrive.
At NEWITY, we specialize in helping small businesses secure working capital through SBA 7(a) loans, which are term loans. Our streamlined process makes it simple for business owners to determine their eligibility. If you don’t qualify for an SBA 7(a) loan, we partner with providers offering lines of credit and other term loan options. If you qualify for their products, we’ll connect you to the right solution to meet your needs.
