Whether you are in the midst of an industrial growth spurt or business startup, situations might arise when you would find yourself in need of financial help. Which one would you choose then? – The business loan or the line of credit? For some, these two terms might turn out to be confusing since most are unaware of the lending process for each of these loan terms. However, a thorough understanding of both the loans will help you to understand the differences, and which of these two would be your suitable business tool that will help you to improve the bottom line better.
In a Nutshell…
What is a business loan?
This kind of loan is used to purchase an asset like a company vehicle or an equipment. The kind of purchase that one makes, is normally reflected as the depreciable asset on the balance sheet. The borrower repays the fixed loan on a monthly basis, which includes both the principal and the interest. So, if you want to purchase an equipment or a vehicle that will show on the balance sheet, then a business loan is what you would need.
What is a business line of credit?
This kind of loan is generally preferred for short term capital needs that might arise during work. Some examples of this kind of capital needs include company payroll, inventory purchases and other future project expenditures. The loans are used to meet out your financial crisis when you could be in dire need of some urgent cash to fill in. Borrowers can repay the loan on an annual basis, where the interest is paid only on the amount that he/she spends.
To help you get a more elaborate picture, let’s get into the differences a little bit in detail and understand how they could serve to propel your business forward.
Business Loan vs. Business Line of Credit
#1 – Necessity
There is a whole lot of difference with regard to the time when you need a business loan and a business line of credit. As already explained above, you get a business loan for one specific purpose. On the other hand, you obtain a LOC prior to when you actually need it since this kind of loan is obtained not just for one specific purpose.
Business loan is fixed and does not change from one month to another. However, a line of credit varies on a monthly basis. That means, in case of business loan even if you do not spend the loan obtained, you will have to repay the necessary amount with interest every month. However, in case of a line of credit, you can make payment only on the amount that you utilize. That means, if your expenditure is zero, the total amount that you would have to repay is also zero.
#3 – Closing Cost
Apart from a few exceptions, the general closing cost of most business loans is anywhere between 2 – 7 percent. A business line of credit on the other hand, has a very minimal or no closing cost.
#4 – Fixed Payment
Business loans come with fixed terms and hence are more expensive. This is because, borrowers need to pay a fixed amount (i.e. the principle and the interest) at the end of every month even if they don’t utilize the entire money. However, in case of the business line of credit, the borrower only pays for the amount that he/she utilizes. That means if the total amount borrowed is $ 50,000 and the borrower had spent only $6,000, then he/she pays the interest only for the $ 6,000 and not the entire amount. If this is a business loan on the other hand, then the borrower needs to pay for the entire amount (on $ 50,000) and not just on the amount that he spends ( i.e. $ 6,000).
#5 – Purpose
Before you apply for any of the two, it is best if you can think over and decide which type of loan would be more suitable to serve your purpose. For this you need to go back to understanding the basics – i.e. how are the loans designed? Business loans are long term loans and hence, are paid off over the span of time that extends from 2 to 6 years. Lines of credit on the other hand, are loans designed to fill in the gap of any unexpected financial crisis that can happen anytime. They are most used for marketing, making payroll and finance receivables.
Therefore, borrowers are recommended to use such type of loans for revenue generation activities or RGA only and less on unnecessary expenditures that could be met out from your personal savings.
#6 – Interest Rates
Since the interest rates of the business line of credit vary and are comparatively lower, the rate can actually get better if you can manage your credit properly.
# 7 – Rate Sensitivity
Business line of credit are designed to serve short term purposes like sudden financial crisis. Hence, such type of loans have a monthly payment that is cash flow friendly in general. The borrower can use the line of credit repeatedly and pay only an interest rate every month, which is comparatively lower than the balance.
With the constant change in lender guidelines, products and the credit standards, the lending landscape for small business organizations have become rather perilous, formidable and delicate. Both these loans have different functionalities to serve. That is why before you apply for a loan, do a thorough research including factors like what you can’t afford and what you can. It will help you to understand better as to which loan type to take.
Read more: Which Home Loan is Right For You?