Small business owners looking to get financing will come across different types of funding available. Two of the most common types of funding that banks, credit unions and alternate lenders give out are business lines of credit and business loans. In order to get the financing that you need for your business to function at its full potential, it's essential to know the differences between a business line of credit versus a loan. Read on to learn more about these two funding sources and to decide which is right for you.
What is a business line of credit?
A business line of credit is a flexible solution for a business that needs financing—lines of credit offer short-term funding to companies in a different way than a standard loan. Once approved, a business gets access to a fixed amount of funding that it can withdraw from when needed. You can then repay the debt over time in a series of payments or immediately as a lump sum without any prepayment penalties.
There are a variety of reasons that businesses use lines of credit. Some of the common uses include:
- Purchasing supplies
- Covering payroll
- Increasing inventory
- Managing seasonal cash flow
- Repairing equipment
- Adopting new technology
- Financing marketing campaigns
- Improving creditworthiness
How does a line of credit work for a business?
If you apply and receive a business line of credit, you’ll have a set amount of money you can draw from for a specified time. During this period of time, you can take out small amounts of money when you need it and pay interest and fees only on what you withdraw. You can pay the money back right away and take more money out later, or you can make payments over a longer period.
What is a business loan?
A business loan is a lump sum of money a company can receive from a lender. In return, the company must repay this amount with interest over an agreed-upon period of time. Companies can use the money from a business loan in many ways, including:
- Starting up costs
- Purchasing real estate
- Hiring staff
- Purchasing equipment
- Purchasing inventory
- Growing the business
- Building creditworthiness
Multiple business loans are available depending on what best suits your company and what eligibility requirements your business meets. Two of the most common types of loans are short-term and long-term business loans. A short-term business loan may need to be repaid in as little as a few months, while a long-term business loan usually lasts between three and 10 years but can have a length of up to 25 years.
Loans through the U.S. Small Business Administration (SBA), called SBA loans, are also available through commercial lenders. These can be both short- and long-term in length but are backed by the government so that the SBA will pay the lender up to 85% of any losses due to a borrower defaulting. The two most common SBA loan programs are the SBA 7(a) loan, which you can use for general business needs, and the SBA 540 loan, which you can use for major purchases. Both SBA loans can reach up to $5 million. SBA loans are great small business loans for women and minorities, as the Small Business Administration puts a priority on being an equal opportunity lender.
How do business loans work?
After receiving a business loan, you repay what you owe in addition to a fixed or variable interest rate and fees accumulated over time. You will typically make payments monthly, but in some cases, you can make payments in daily or weekly intervals.
Loans can either be secured or unsecured business loans. You can use collateral, such as business equipment or inventory, to back a secured loan. If you cannot repay your secured loan, the lender can take the collateral as payment. An unsecured loan isn’t backed by collateral, so if you cannot pay back the loan, the lender could take you to court or sell your debt to a debt collector.
What is the difference between a business loan and a line of credit?
Both a business loan and a line of credit are tools that companies can use to improve their business. There are many differences between these two types of funding, including funding amounts, repayment structures, forms of collateral and credit and revenue requirements.
Business loans and lines of credit differ in terms of funding. When you apply for a business loan, you receive the total amount all at once. You also must pay interest on the total amount once you receive the funds. Because of this, it’s a good idea to make sure that you’ve decided exactly how much financing you’ll need and that the loan matches that amount. If you take out a loan that is larger than what you need, you’ll be paying unnecessary interest.
When receiving a business line of credit, a lender gives you access to a certain amount of money. You will only pay interest on the amount you draw from the line of credit, not the overall amount. In this case, you can apply for a larger amount of credit that you can use as a safety net for worst-case scenarios without paying interest on the larger amount.
There isn’t any rule or standard for the total amount of funding you can receive from a business loan or line of credit. The amounts will differ depending on the lender. For example, OnDeck offers business term loans from $5,000 to $250,000 and lines of credit from $6,000 to $100,000. A different lender, Quickbridge, has business loans of up to $400,000 but has no lines of credit available.
However, business loans tend to be larger than lines of credit as businesses use loans for larger-scale projects that can involve purchasing property or equipment, while business lines of credit are for covering operational expenses.
Lenders dispense business loans as a lump sum, so you immediately start repaying the loan over a set repayment schedule. As you pay off more of the principal, you accrue less interest and can repay the loan faster.
Business lines of credit differ significantly. You only accrue interest on the funds you’ve drawn from your credit. If you withdraw 10% of the total amount available, you can pay that back whenever you have the funds and then withdraw an additional amount later. If you cannot repay that amount in the short term, you can still withdraw the remaining 90% as long as you make the regular payments.
Lines of credit have a limited draw period. After the draw period ends, you cannot withdraw funds from your line of credit any longer and will need to repay your outstanding debt over a set repayment period, much like a loan.
Form of collateral
While unsecured business loans are available, many lenders will ask for some form of collateral. You can back secured loans with many different types of assets, like real estate, inventory, equipment or cash. Some lenders offer a secured business line of credit, but many lenders offer companies a business unsecured line of credit that doesn’t require collateral.
Credit and revenue requirements
To qualify for both types of financing, lenders will look at annual revenues, time in business and business credit rating, although the requirements will vary. While each lender has different qualification standards, getting approved for a business line of credit is generally easier than getting a loan. If you cannot get approved for bad credit small business loans, you may want to consider a line of credit.
For example, a lender may require a business credit score of 680 or higher with an annual revenue of $500,000 to qualify for a business loan. To get a line of credit for small businesses from this same company, you may only need a business credit score of 600 or higher and an annual revenue of $100,000.
How to get a business loan
Getting a business loan will take some time and effort. You can apply for a business loan from several types of lenders, including banks, credit unions or alternative lenders, which are completely online. Once you have a reason for taking out a loan and have determined how much you want to take out, you’ll want to research multiple lenders and determine which one has the best small business loans.
Some lenders are very transparent about their eligibility requirements and business loan interest rates and fees with the information listed on their websites. Other lenders may require more research, and you will need to call and speak with a representative or meet with one in person. Before applying, you’ll need to know if your business will qualify for the loan. Otherwise, you may end up wasting your time. Some lenders provide no-doc business loans that require minimal materials to apply, but these loans also tend to have higher interest rates.
After you find a lender, you must go through the process of gathering the necessary documents and materials needed to apply. Submit the materials along with your application and then wait for your funding to come through.
How to get a business line of credit
Like applying for a business loan, the process of getting a business line of credit will vary by lender. You may want to consider applying for more than you need because you don’t have to use all the funds available to you when you receive a line of credit. Unlike a loan, you won’t need to pay interest on the total amount, only what you withdraw.
Once you know how much financing you need, you’ll want to look at several lenders to find the best fit. There are sites online where you can compare the best business line of credit options. Research multiple lenders and take note of their eligibility requirements to determine if your business will meet that standard. After finding a lender, you’d like to apply to, gather all the necessary documentation and apply.
Business Line of Credit vs Loan FAQ
How much loan can I get for a business?
The purpose of your loan and if you back it up with collateral will affect the price also. Some lenders will loan millions of dollars, but many small business loans are for $500,000 or less.
How much business line of credit can I get?
What is a business line of credit used for?
Should I get a business loan or a line of credit?
Summary of Money’s business line of credit vs loan
Determining whether to get a business loan or a business line of credit will depend on the needs of your business. Loans can provide larger amounts of financing for specific purposes. Business lines of credit are funds you can use to assist in your day-to-day operations. Both are useful tools for business owners and can help you grow your business.