Business line of credit vs loan: understanding the key differences and choosing the right option

What is a business loan?

A business loan is typically a lump sum of money provided by a lender to a borrower. The lump sum can be subject to interest charges or up-front fees and is repaid over time. A business owner can apply for a business loan to cover large or long-term expenses, such as equipment or real estate purchases.

Business loans can cover significant expenses and can also be utilized for various purposes, such as managing cash flow, funding franchise expansion plans, or refinancing existing debt.

The terms and conditions of business loans can differ significantly based on the lender. It is crucial for business owners to carefully assess the loan fees and compare various lenders to determine which financing solution is best suited for their unique circumstances.

How does a business loan work?

Lenders will usually set their own business loan terms based on a borrower’s application, credit history, and financial standing. A borrower with a strong credit score, for example, may receive a lower interest rate for their loan. Whereas someone with a lower credit score may require collateral or only be offered higher interest rates to have their loan approved.

Business loans are typically repaid in monthly installments over a set period of time, such as several months or years. How much you’ll pay depends on the interest rate of your loan, the term, and whether you’ve gone with a fixed or variable interest rate.

A fixed interest rate business loan is a type of loan where the interest rate stays the same throughout the entire repayment period. This means that the monthly payments will be predictable and won’t change due to fluctuations in market interest rates. Fixed interest rate loans offer stability and simplify the process for businesses to budget and plan their finances.

On the other hand, a variable interest rate business loan is one where the interest rate can change based on market conditions. Unlike fixed-rate loans, the interest rate on a variable rate loan is typically linked to a benchmark rate, such as the prime rate established by the lender. This type of loan can be beneficial if interest rates decrease, potentially lowering the cost of borrowing, but it also comes with the risk of higher payments if interest rates climb.

Potential pros and cons of business loans

When considering financing options for your business, it's important to weigh the pros and cons of business loans. These loans can provide much-needed capital to grow and sustain your operations, but they also come with risks and obligations. Understanding the advantages and disadvantages of taking out a business loan can help you make an informed decision that aligns with your business needs.

Some of the most notable advantages of business loans may include:

• Predictable payments: Pay back funds in set, predictable installments over time when opting for a fixed interest rate business loan.

• Large loan amounts: Borrow large amounts of money to pay for hefty expenses, such as launching new products, funding an ad campaign, or hiring additional staff. Alternatively, the money can be used for startup funding to help you get off the ground.

As for potential disadvantages, business owners should be aware of the following:

• Lengthy application processes: Borrowers may need to provide detailed documentation and collateral to receive a business loan. It may take days or weeks to gather all the information.

• Strict credit requirements: Traditional lenders may require a certain credit history or credit score for business loan approval. If your credit score is low, you may be denied right away.

• Credit score reduction: The process can impact your credit score for business loan applications. Each time you apply for a loan, the lender will perform a credit check, which may result in a hard inquiry on your credit report. Multiple checks within a short period might make it challenging to secure favorable loan terms.

What is a business line of credit?

A business line of credit is a type of financing that lets borrowers withdraw money as they need it, similar to a credit card. Once you pay off your balance, the funds are replenished, so you can continue spending as long as you don’t exceed your credit limit.

How does a business line of credit work?

Business owners can generally use a line of credit to withdraw cash for any type of business expenses or purchases for the business. They then pay off their outstanding balance plus any interest or fees each month.

Unlike a business credit card, a business lines of credit often provides a lower interest rate and higher credit limit, making them a more cost-effective option for business financing, managing cash flow, and covering short or long-term expenses. Additionally, business lines of credit typically require a more thorough application process, whereas credit cards are usually simple.

Potential pros and cons of business lines of credit

Business lines of credit provide flexibility and easy access to funds, making them ideal for managing cash flow and covering unexpected expenses. However, they may have variable interest rates and require collateral, which can pose risks if not managed carefully. Balancing these pros and cons of business lines of credit is important for increasing the benefits of this financing option.

Some of the advantages of opening a business line of credit include:

• Flexibility: Once approved, you can draw funds as needed and only pay interest or fees on what you borrow. There are no ongoing costs if you haven’t borrowed anything.

• Improved cash flow: Have a revolving pool of cash on hand to cover unexpected or seasonal changes in business cash flow while being able to react to unforeseen opportunities.

Disadvantages of getting a business line of credit may include:

• High interest rates: Business lines of credit may come with high and more variable interest rates or fees compared to business loans.

• Unpredictable payments: Monthly payments can change based on how much you borrow and fluctuations in your interest rate or fees. With a variable interest rate, the rate can increase or decrease over time. While your payments may decrease if interest rates fall, you would also see higher payments in a rising interest rate environment.

Business line of credit vs. business loan

What is the difference between a business loan and a business line of credit? It’s important to compare and contrast a business loan vs. a line of credit. There are key differences between these two business financing options, including:

• Borrowing amounts: Business loans usually provide higher borrowing amounts and are paid back over extended periods, making them appropriate for major expenses such as buying equipment or real estate. Conversely, lines of credit offer the flexibility to access money as needed, which is perfect for managing cash flow and addressing short or long-term expenses.

• Interest rates: Business loans typically feature lower interest rates compared to lines of credit, making them a more cost-effective choice for long-term financing. While lines of credit may carry higher interest rates, they provide more flexibility and convenience since you can use them as needed.

• Payments: Business loan payments are typically steady and predictable when using a fixed rate since they feature set monthly payments that are easy to budget for. In contrast, line of credit payments may vary over time depending on the amount borrowed and changes in interest rates. This variability can complicate predicting and managing your monthly budget.

Understanding these differences helps you choose the financing option that best fits your business needs.

How to choose which business financing option is better for you

When choosing between a business line of credit vs. loan, you should assess your individual business needs, financial goals, and risk tolerance. It’s also important to research options and speak to a trusted financial advisor.

As you get started, you can ask yourself these questions to help make an informed decision and determine the right choice for your specific situation:

• Am I seeking short term funding or long term funding?

• Do I know how much money I need upfront? Or do I want the flexibility to withdraw funds over time?

• How long will I need to pay back my loan?

• How much can I afford each month in debt repayment?

• Do I want a fixed or variable interest rate? How much interest am I able and willing to pay?

• Do I want to make fixed and predictable payments or fluctuating payments based on how much I borrow?

• Will I want the option and flexibility to pay off my loan early?

• Can I expand my business with this business loan or business line of credit?

Where to apply for business loans and lines of credit

When considering where to apply for business loans and lines of credit, you have several options. Many banks and credit unions offer solutions for businesses and often provide competitive interest rates and personalized service.

Each lender has its own application process. To be approved, you may need to provide important information, such as financial statements and tax returns, your credit score and a business license. Additionally, some lenders may also require a detailed business plan and proof of revenue.

Understanding what collateral is important during the application and loan process. For secured loans or lines of credit, lenders often require collateral — meaning an asset pledged by the borrower to secure the loan.

Common forms of collateral include real estate, equipment, and inventory. Providing collateral can improve your chances of approval and may result in more favorable loan terms, such as lower interest rates. However, if you default on the loan, the lender typically has the right to seize the collateral to recover their losses.

Unsecured loans and lines of credit don’t require collateral, but they typically come with higher interest rates and stricter eligibility criteria. Lenders are likely to place greater emphasis on your credit score, financial history, and overall business health when evaluating your application.

By comprehending how the application process works and the role of collateral, you can navigate the options available and choose a good financing solution for your business needs.

Learn more about how to apply for a PayPal business loan.

Alternative financing options

Entrepreneurs can consider other business financing options outside of loans and lines of credit. Here are some examples of funding options:

• Business debit or credit cards: Separate your personal card accounts from your business accounts and potentially earn rewards for certain purchases.

• Merchant cash advances: Receive a lump sum of money as a merchant cash advance and pay it back using a percentage of your daily or weekly sales.

• Crowdfunding: Gather donations from supporters and community members.

• Peer-to-peer lending: Use peer-to-peer lending apps to borrow money directly from investors.

• Private investors: There are wealthy business investors who may be interested in funding your business in exchange for equity or a share of the profits.

As with business loans and lines of credit, each of these alternative financing options come with their own pros and cons. You should carefully evaluate any financing options before moving forward. Consider consulting trusted advisors when making a decision.