Business Line of Credit vs. Loan: Key Differences to Help You Decide Which to Use
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Small business owners looking to get financing will come across different options to borrow funds. 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.
To get the financing that you need for your business to function at its full potential, it's essential to understand the differences between a business line of credit versus a loan.
Here’s what you need to know about these two funding sources 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. The business 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. In that sense, it’s a revolving type of credit, much like a credit card: 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:
- Covering startup costs
- Purchasing real estate
- Renovating
- Hiring staff
- Purchasing equipment
- Purchasing inventory
- Growing the business
- Building creditworthiness
Multiple types of business loans are available depending on what best suits your company and its needs. 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 has a term length between 3 and 10 years but can have a length of up to 25 years.
Many businesses may look to the U.S. Small Business Administration (SBA) to borrow money. These loans are also available through commercial lenders, though they're backed by the government. The SBA will pay a lender up to 90% 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 504 loan, which you can use for major purchases. The maximum loan amount for the 7(a) program is $5 million; the max for a 504 loan is $5.5 million.
How do business loans work?
After receiving a business loan, you start to repay what you borrowed in addition to a fixed or variable interest rate and any fees. You will typically make payments monthly, but in some cases you can make payments in 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.
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 for your purposes.
Some lenders are very transparent online about their eligibility requirements, interest rates and fees. Other lenders may require a phone call or in-person meeting to speak with a representative. After you find a lender, you must go through the process of gathering the necessary documents and materials, including tax returns, bank statements and your business plan.
Main differences between business loans and lines of credit
Business loans and lines of credit are both tools that companies can use to access funds. There are several differences between these two types of financing, including funding amounts and credit and revenue requirements.
Funding amounts
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, so 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 because you don’t pay interest unless you tap the funds.
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, one of the standout small business loan lenders on Money’s list of the best options, 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.
In general, business loan limits 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.
Credit and revenue requirements
To qualify for both types of financing, lenders will look at annual revenues, how long the company has been in business and the business’s 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 a small business loan because of your credit, you may want to consider a line of credit.