Business Loan or Line of Credit: What You Need to Know

Natalia Autenrieth In her professional lives across the United States, Natalia Autenrieth, CPA has audited Fortune 500 clients as part of a Big 4 team, built an accounting department as a controller of a large hospital, and served as a CPA consultant to municipalities. Today, Natalia coaches in the financial industry and writes about business finance, financial technology, and personal money management. Her ghost-written articles have appeared in thought leadership and expert blogs, as well as Kiplinger and Accounting Today. Read more about Natalia and her practice at www.AutenriethAdvantage.com.

Business Loan or Line of Credit: What You Need to Know

Among the many challenges that business owners across the country have to contend with, many financial difficulties and cash flow are high on the list. According to a recent study by the Federal Reserve Bank, 61% of small businesses surveyed have reported having experienced difficulty covering operating expenses, making debt payments, purchasing inventory or securing financing in the previous 12 months.

The same survey found that 76% of firms with financial challenges have relied on the owner’s personal funds to address the problem. However, expanding businesses and local economic challenges sometimes require that business owners reach for financing beyond their individual reserves. Those who apply for small business financing must have a clear understanding of their options, the application process and the long-term impact of their choices.

Business loans and lines of credit are two popular but often confused methods of financing. Here is what you need to know.

Defining the options: business loans and lines of credit

A business loan is usually issued under a series of fixed terms (in other words, you agree to a certain set of conditions). For example, you might wish to borrow $150,000 which will be repaid in 3 years.

A loan may be secured by collateral (an asset that the bank can use to reduce its loan risk) such as commercial real estate, a retail location, equipment or a vehicle that will help the bank recoup the loan in the event of non-payment. A secured loan will typically command a lower interest rate than a non-secured loan.

In contrast, a business line of credit is an open-ended “credit card”-like arrangement for your business, but without the actual plastic credit card. Because a line of credit can be used and re-paid on as-needed basis, there is no fixed term. A typical credit line arrangement includes an interest rate and minimum monthly payments, similar to your personal credit card.

Which is better for your business?

The answer depends on several factors.

Generally, a line of credit is used for just-in-time working capital needs (such as buying inventory, making minor improvements, or helping you fund payroll to cover the temporary delay on client payments). In contrast, a business loan is typically used for financing large expenditures (such as a large piece of equipment or a major remodeling effort). Businesses often apply for a line of credit to have a “just in case” cashflow safety net, while a business loan is usually requested for a defined purpose.

While specifics vary, a business loan tends to require more prerequisites, including strong business financials and sometimes collateral – in addition to clean credit history. A line of credit is often granted on the strength of credit history alone, which makes it a good choice for startup businesses.

Finally, business loans often have one-time closing costs (2-7% is standard) in addition to the interest charge. There are no closing costs for a line of credit arrangement.

Here are some examples that might call for a business line of credit or a business loan.

  • Challenge: You own a construction company and get paid in installments based on project progress. Your crew has just completed a big job, with inspection due mid-next week. The final payment from the client is expected at the end of next week. In the meanwhile, you must pay your crew this Friday.
  • Solution: Tapping into a business line of credit can allow you to cover payroll. You can make the payment on the line of credit when the money comes in to minimize your interest expense.
  • Challenge: You have run a design and printing shop for over 5 years and are well-known in the area for great customer service. You want to buy a CNC router machine that will allow you to etch computer-generated graphics into plastics, wood or metal. The acquisition will expand your range of service offerings and boost your bottom line. Expected useful life of a CNC router is about 5 years.
  • Solution: A 5-year business loan would match the expected useful life of the CNC router, allowing you to match the additional revenue it will bring in with loan repayments.

Business loan or line of credit?

In summary, ongoing working capital needs are best funded through the use of a line of credit, while business loans are better suited for large one-time projects. No matter which method of financing you select, be sure to read the fine print and do the math carefully. Consider the interest rate (or the range of interest rates if the rate is variable), look at your business cash flows to make sure minimal monthly payments won’t stretch your resources too thin, and ask about any other fees that you should know about. Finally, be sure to work with a local expert that can help you match your business needs to the best financing option available.

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