Business Line of Credit vs. Loan: Which Is Best for Your Business?

Every business needs funds to operate successfully, but not every small business owner has ready access to the external funding they need. Additional financing from external sources (different from the business or the business owner's own money) is often necessary to get a business off the ground, keep it going, or at least bridge the business when cash flow is low or negative at particular points of time.

Business owners have many options when it comes to financing depending on their current financial situation, business needs, and growth plans. Two such popular options are a business line of credit (LOC) and business loans.

In this article, we’ll look at the differences between a business LOC and business loans to help you better understand if and when you should use either one for your business.

How a Business Line of Credit Works

A business line of credit (LOC) works like a business credit card in that it is revolving and subject to credit review and annual renewal. However, it can be a great way for business owners looking for a short-term, temporary financial fix to access cash without going through the process of applying for and potentially being denied a loan.

A LOC provides funding flexibility for business owners: businesses can borrow some or all of the amount allowed in the LOC as needed in time and pay down their balances on a revolving basis. They can also borrow the maximum amount, pay the interest on it, and then pay it off in full when it is the right time, following the cash flow fluctuations of their business.

Types of Business Lines of Credit

If a business LOC seems like a viable option, the first thing to consider is the type of line that you need. There are two main types: secured and unsecured.

• A secured line (or asset-based line) requires collateral in the form of assets such as real estate, cash, or personal property, which the bank will use to recoup the loan if you default on payments.
• An unsecured line does not require collateral. However, because of the risk to the lender, it is often more expensive than secured LOC due to higher interest rates and fees, and issued with a lower credit limit.

How a Business Loan Works

A business loan is fixed-term financing offered by banking institutions and used to fund business operations. There are different types of business loans available to businesses for purposes such as:

• Buying something valuable for the business (e.g., software, property, renovations)
• Investing in the growth of the company (e.g., startups developing new products or services)
• Paying off debts or recovering from economic disasters
• Purchasing inventory or equipment

Types of Business Loans

Small business owners have several options when it comes to business loans. Here are some common types:

• Traditional term loan: This type of loan has a fixed repayment schedule and an interest rate that can change over time. Lenders generally expect term loans to be paid back in full within one to five years. They are often backed by collateral such as business property or equipment.
• U.S. Small Business Administration (SBA) loans: SBA loans such as 7(a) or 504 are approved by the SBA and distributed through lenders. SBA backing can improve your chances of getting better rates, higher loan amounts, and better loan features.
• Unsecured (or “cash flow”) business loan: This type of loan is generally used for working capital and typically doesn't require collateral for the bank to seize in case of default. However, it requires monthly payments based on cash-flow projections, and usually requires a business credit rating and personal guarantee in lieu of collateral.

Choosing the right funding method will depend on the individual business owner, based on a variety of factors such as their industry, credit score, cash flow, financial history, and more.

Business LOC vs. Loan

This table provides an outline of some of the key differences between business LOC and loans.

Categories Explained

• Funding range: Generally, business loans are offered in more substantial borrowing amounts compared to LOCs, but not always.
• APR (Annual Interest Rates and Fees): Most small business loans feature higher rates than comparable LOCs, but the lender and your financial status primarily determine this. Online lenders tend to charge higher rates overall than brick-and-mortar banks.
• Repayment schedules: Business loans typically have fixed payment schedules, and you'll need to make payments right away. A business LOC doesn't come with such stringent terms; you only need to make payments to the line of credit after you start borrowing.
• Term length: Terms lengths can vary depending on the type of loan, line of credit, and the lender. Generally, LOCs have shorter term lengths than loans because they’re designed for short-term business needs—although some terms can last up to five years.
• Credit score: Small business LOCs typically require a lower minimum credit because the loan amounts are usually short term and lower than standard business and SBA loans. However, the requirements for each small business funding option can vary significantly by lender.

Which Is Right for Your Business?

Now that you’ve learned some differences between business LOCs and loans, which option works best for you?

Here are some factors to keep in mind:

• How do your business’s financial qualifications look (current credit score, years in business, monthly revenues, etc.)?
• How fast do you need the money?
• What will the amount be used for and when?
• What amount of interest can you budget for?

When a Line of Credit Is Right for You

A line of credit is a good option if you need flexible funding up to a specific limit and want to repay the debt in small chunks over time. Lines of credit are unsecured, or “flex,” loans that give you access to funds as you need them without the burden of providing collateral and dealing with more rigid repayment terms. This flexible option is ideal for evolving, quickly growing businesses that have changing, often short-term financial needs such as covering cost of labor and supplies, adding inventory, or making crucial repairs to equipment.

When a Loan Is Right for You

A business loan can be a great way to make your long-term vision a reality. It can help with more significant financial expenditures such as improving essential infrastructure, purchasing needed equipment, or expanding your operations. Whatever the case may be, loans are a reliable, steady way to help your business grow and succeed financially.