Line of Credit vs. Term Loan: Which Is Best for My Business?

A term loan is likely what you think of when you imagine a traditional business loan. With a term loan, you receive a lump sum of capital that you pay back over a specific time period (or “term”) with a set interest rate, which might be fixed or variable.

Term loans typically have repayment terms of one to five years with amounts ranging from $25,000 to $500,000. No matter when you start using the money from your term loan, you will start making payments to the lender immediately, and these payments will be on a set schedule (anywhere from daily to monthly).

Keep in mind, term loans can also come with fees besides interest, including origination fees, packaging fees, prepayment penalties, and so on. A term loan calculator can help you see how much debt you can afford.

A business line of credit is one of the most flexible financing products on the market. You can think of a line of credit as a more powerful credit card. If approved, a lender will extend you a credit limit (say, $50,000, for instance) from which you can draw against at any time and for any business purpose.

Unlike a term loan, you only pay back what you use (plus interest). Another unique quality of lines of credit is they are usually revolving, meaning once you pay back what you’ve used, your balance refills to its original value and you can draw against it again and again. Therefore, many businesses keep lines of credit in their back pocket for unexpected emergencies or opportunities they need to react to quickly.

Lines of credit can range from $10,000 to over $1 million and, while they don’t have hard-and-fast term lengths like term loans do, typically you may have between six months and five years. As with term loans, you’ll want to make sure you understand all of the fees associated with your line of credit. Depending on the lender, you may be subject to draw fees, inactivity fees, withdrawal minimums and more.

Now that you have a general understanding of both business term loans and lines of credit, let’s take a closer look at how these two financing products differ.

• Repayment Structure: While term loans have a set, predictable repayment structure where you make payments of equal size at equal time increments, lines of credit are much more fluid. Since you only have to repay what you use, you may have your line of credit for months before you start making payments. As such, lines of credit don’t have such defined terms.
• Fees: A line of credit typically has a lower interest rate and closing costs than a loan of comparable size. However, if you’re late with a payment or go over your borrowing limit, your line of credit interest rate may increase substantially—unlike a term loan, where the interest rate stays the same for the life of the loan. Additionally, depending on your lender, your line of credit may have draw or inactivity fees. Term loans, on the other hand, may have prepayment penalties, origination fees, and more.
• Requirements: When comparing a business term loan vs. line of credit, it’s easier to qualify for a line of credit. Borrowers can be approved for lines of credit with lower credit scores and revenue and less time in business, making them the more accessible option.
• Uses: While both term loans and lines of credit can provide your business with some much-needed capital, they have different use cases. Term loans are best for specific, one-off purchases. You need to know what you’re looking to finance and how much capital you need before applying for a term loan. Lines of credit, on the other hand, are best for ongoing operating expenses. This type of financing is much more flexible and is usually revolving, meaning you don’t have to reapply each time you use and repay your loan.

While there are many differences between term loans vs. lines of credit, these financing products do have some things in common.

• Flexible Capital: Term loans and lines of credit work best in different business scenarios; however, they are both flexible loan products in that you can use the proceeds for any business-related expense. Some types of financing, like equipment financing or SBA 504/CDC loans, dictate exactly what you can use them for (in this case, specific equipment or real estate, respectively).
• Lenders: Both term loans and lines of credit are offered through traditional banks as well as online, alternative lenders. While requirements differ between products, you can be sure that the stronger your business credentials (credit score, business history, revenue), the better terms you can expect—in this case, lower interest rates, longer repayment terms, larger capital amounts.
• Short-Term Options: Lastly, if you find that you can’t quite meet the requirements for either a term loan or line of credit, or if you need a smaller amount of capital quickly, both loan products offer short-term options that may better fit your needs. With short-term loans, you can access up to $250,000 with terms between three and 18 months. You should have at least a 600 credit score and two years in business. For short-term lines of credit, you’ll need a 500 credit score or higher, at least six months in business, and $25,000 in revenue. Because of the shorter terms, these are more expensive financing options but can be viable options for newer businesses with less-than-stellar credentials.

When deciding which is best for your business, the first thing you should consider is what you need to use the funds for. If you need to finance a specific, one-time expense, then a term loan is your best option. However, if you’re looking for funds to cover ongoing operating expenses or you want a reserve to keep in case of an emergency, then a line of credit is best for you.

While these are two very different financing solutions, both term loans and lines of credit offer flexible solutions for your business. With a strong credit score, at least a year in business, and solid revenue, you have the best chance to be approved for the amount you need with the most favorable repayment terms.