A loan is pretty easy to understand, though the paperwork may be more than a bit confusing - even to a company owner. The lender gives the loan recipient money to be repaid over a period of months or years. In exchange for the loan, the loan recipient pays interest on money received. That's the incentive for the lender to hand over the cash in the first place. The lender puts its money to work earning interest paid by the borrower.
A line of credit is a loan with numerous benefits to borrowers. Here's how a line of credit works:
The bank approves your company for a $50,000 line of credit. That means your company can borrow up to $50,000 but isn't required to borrow that amount. With a straight, term loan you receive the entire $50,000 up front and pay interest on the full amount starting on Day One.
With a line of credit, your business has flexibility to choose when and how much capital to use. For instance, your company may decide to draw $5,000 on its $50,000 credit line. In this case, your monthly payment and interest charge is based on the $5,000 actually borrowed, not on the entire $50,000 credit line, saving you a lot on interest payments.
In subsequent months, if you draw more from the credit line, your payments increase along with interest charges. You can pay back and "re-borrow" from a credit line so you have a cash cushion when your business needs it.
In the case of a loan, funds are disbursed up front and interest on the entire loan amount is due each month whether your business uses the capital or not. A credit line is used when funds are needed and for whatever reasons company management deems appropriate for business growth.
Which type of credit is right for your company? Let's take a closer look.
Interest is charged on the outstanding balance of the loan, and the interest rate charge is usually fixed. Term loans make sense when a company needs funds for a specific purpose: an equipment purchase, capital improvements, facilities expansion, marketing and other business expenses.
- Term loans give your company the full loan amount up front. The money is then repaid in prearranged monthly installments throughout the term of the loan. The term of a commercial loan typically ranges from one to 15 years.
Think of a term loan as a, "I know what I need and when I need it" loan.
Interest is charged on the outstanding balance and not on the unused portion of the line of credit. Interest rates are almost always variable and are tied to a standard index like the prime rate. Think of a line of credit as a, "I know I'll need funds but I'm not exactly sure when" loan.
- Lines of credit give your company the option of borrowing as much money as you need, when you need it, up to a pre-arranged maximum amount.
Qualifying for a line of credit is typically more difficult than qualifying for a loan. A loan, made to purchase equipment or to purchase a facility, for example, uses that equipment or facility as collateral to cover the loan amount in case the company defaults and is unable to repay the loan.
With a line of credit, the choice of how funds are used is left to the discretion of the borrower, and, therefore, carries more risk to the lender because the borrowed funds may or may not result in collateral sufficient to secure the loan.
How does your business qualify for a line of credit?
A good business credit rating and a solid, company financial history are required. Few lenders will approve lines of credit for start-ups or businesses without a track record of financial success.
Be prepared to provide financial documentation like profit and loss statements, balance sheets and company tax returns when applying for a credit line.
Other collateral to secure a line of credit is also required. A business line of credit is almost always asset-based, with hard assets, like equipment or facilities, used as collateral to back the credit line. Credit lines can also be secured by receivables and even inventory though inventory securitization is less likely because the value of inventory can decrease rapidly, especially with seasonal or cyclical businesses.
Here's the main difference between a loan and a credit line: a loan lets you make a specific purchase; a credit line provides some amount of security that you have funds available if you run into unexpected problems or financial difficulties.
Deciding whether to choose a line of credit or a term loan should be based on how much capital you need, how long you need it and when you can pay it back. A line of credit can be paid down any time. So can a commercial term loan through an accelerated payment plan that doesn't penalize your business for early payments.
Think ahead and plan how and when the infusion of capital will be used and for how long. The decision becomes simpler when you, the business owner, know how the capital will be used.