It’s important for small business owners to understand the different types of financing available to make the best decisions in regard to debt and financing growth. The two basic types of financing commonly used by small businesses are term loans and lines of credit.
Small business owners need to understand the differences between these two financing options, as each has advantages and disadvantages. The purpose of the loan, what the money will be used for, is often the determining factor in selecting the appropriate means of financing.
A Term Loan
A standard term loan is the method of financing most people are familiar with, from the purchase of a car or other major asset. With a term loan, a set sum of cash is loaned to the borrower at the closing of the loan. The loan is then paid back in regular, usually equal, monthly payments. Term loans are typically fixed-rate loans.
Typical uses for term loans are to finance the purchase of a major asset, such as manufacturing equipment, property, company vehicles, leasehold improvements, and computer hardware or software. The main consideration that makes term loans most appropriate to handle such purchases is that they all represent significant assets that continue to provide value to the business for a long period of time.
A Line of Credit
A line of credit is not so much an outright loan as an agreement between the business owner and his bank regarding the maximum amount of credit the bank is willing to extend to him without requiring collateral or a new assessment of his creditworthiness. A line of credit is similar to a credit card. For example, assume a business owner is granted a line of credit up to $25,000. It’s essentially the same as obtaining a credit card with a $25,000 credit limit. The business owner can draw money against the line of credit, as needed, up to the $25,000 limit.
Lines of credit are often structured on a variable rate basis, adjusted periodically in accord with the prime rate or some other benchmark interest rate.
Common uses for accessing a line of credit are to meet operating expenses if the company’s cash flow is temporarily inadequate, or to cover expansion costs, such as a situation in which the business acquires an important new customer but incurs substantial out-of-pocket expenses prior to the time when the customer’s first bill comes due.
One of the main differences between term loans and lines of credit is the payment amount or schedule. Loans usually have a fixed monthly payment amount that includes both principal and interest, and the loan is for a definite period of time, such as 10 years. Payments on money borrowed via a line of credit vary from month to month, depending on how much of the available credit the borrower has accessed. Payments may also vary with changing interest rates if the line of credit is a Variable interest Rate arrangement. A line of credit is revolving, again like a credit card, not set to be paid back in full within any certain time frame.
Fees associated with loans include a processing fee, a credit check fee, and an appraisal fee if the loan was collateralized. A line of credit usually involves a processing fee, credit fee, and then a fee is charged each time the borrower draws out additional cash against the line of credit. For example, the borrower might be charged $25 for each draw against the line of credit. For this reason, borrowers need to anticipate financing needs so that they can make less frequent draws and keep fees to a minimum. Closing costs are usually higher for a loan than for a line of credit.
Loans are best used for acquiring long-term business assets, whereas a line of credit works best for short-term operating expenses, such as financing a marketing campaign. Ideally, line of credit funds are used for revenue-generating activities that produce sufficient additional revenue to pay down the line of credit in short order.