Business loans and commercial lines of credit (LOC) are both useful tools for business owners who are looking for financing for their companies. However, some entrepreneurs are not sure how the two differ from each other and which one is more suitable for their needs, so let’s compare and contrast these two funding options.
How you get the funds and how you repay
When people say “loans,” they are usually referring to installment loans. The borrower gets the loan amount as a lump sum of money and repays the loan (plus interest) through regularly scheduled payments over a predetermined length of time. Each payment is usually the same amount and the repayment period lasts anywhere from a few months (with alternative lenders) to a few decades (with banks and other traditional lenders).
A line of credit, meanwhile, works similar to a credit card. The lender assigns you a limit and you can borrow funds as long as you don’t exceed that credit limit. You pay interest on the borrowed amount and once you’ve repaid the money, the limit is then reset. For example, if you have a $10,000 limit and you withdraw $4,000, you still have $6,000 available for use. After paying back the $4,000, you can now again borrow up to $10,000.
What you need the money for
Generally speaking, a small business loan is more suitable for a long-term expense or a large, one-time expense, such as an expansion project or equipment purchase. Some lenders also require borrowers to state their specific loan purpose and that purpose affects the lender’s decision when approving loan applications.
A business line of credit, meanwhile, is a good choice for small, ongoing or variable business expenses, such as office supplies or unexpected expenses. The limit gets reset when you pay back the money and you do not have to constantly reapply whenever you need funds, nor do you need the lender’s approval on what you can spend the money on. Thus, some business owners get a line of credit purely for peace of mind, since its flexibility makes it a quick and convenient funding source, just in case they will suddenly need money someday.
When it comes to loans, the interest you have to pay is computed based on the whole loan amount. It also typically starts accumulating as soon as you receive the money, whether or not you will be using the entire amount in one fell swoop.
With a line of credit, on the other hand, you only have to pay interest on the money that you actually used—not the whole credit limit—and the interest starts accruing only after you have withdrawn money from your LOC, not upon opening your account.
In addition, loans typically come with fixed interest rates, which means that if your loan has a 4% interest rate, the rate will be 4% for the whole duration of the loan.
In contrast, many lines of credit have variable rates. The rate is normally based on the Wall Street Journal Prime Rate plus a little margin. For example, a lender might quote the rate as the Prime Rate plus 2%, so if the Prime Rate is 4%, the interest rate would be 6%. When the Prime Rate changes, the interest rate will also change.
Loans and lines of credit also have different fees. With loans, you will need to pay processing fees and appraisal fees. With lines of credit, you have to pay for initial processing fees and you may be charged a transaction fee each time you draw money from your LOC.
The closing costs for business loans typically range from 2 to 7 percent. They are, on average, higher than those for commercial lines of credit.
While both business loans and lines of credit enable entrepreneurs to secure funding for their business needs, there are significant differences between the two. With a loan, the borrower gets a lump sum of money that he has to consistently repay over a fixed period. With a line of credit, on the other hand, the borrower gets a revolving account and he can draw and repay from that account repeatedly. Which one is a better choice depends on the kind of business expense you will use the money on.