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What’s the Difference Between Term Loans and Lines of Credit?
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Term loans and lines of credit are two popular lending options for funding small businesses, but they have a few key differences.
Term loans pay out in a lump sum, and you need to start repaying them immediately. Usually, the repayment term is set on this kind of loan, so you start repaying the amount right away and only for a set period of time.
In contrast, lines of credit come with a set limit that you can draw money from as needed. They don’t require repayment until you begin charging purchases to them.
Not sure which type of business funding is right for you? Below, we explore the differences between lines of credit and term loans, plus explain how these two options can work to fund your business.
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Funding your business with term loans or lines of credit
Term loans and small business lines of credit are both options for funding your business activities. Some small businesses may prefer to have both, since one provides a lump sum of money upfront, while the other gives you the opportunity to take out money only when you need it.
These two ways of financing your business are common, but remember that you should always review the terms of the contracts, making sure the interest rates, terms, and conditions fit your business’s needs and budget.
Additionally, you might not qualify for all types of term loans or lines of credit. Don’t waste time applying for loans you don’t qualify for—always review requirements like minimum time in business, minimum annual income, and other restrictions before applying. And if you don’t qualify for either a term loan or line of credit, you do have other funding options, including personal loans and nontraditional lenders.
Now that we’re clear on some business lending basics, let’s dive into the differences between these two popular business financing options.
What are term loans?
Term loans are lump-sum loans set up over a specific repayment period during which the principal amount (or the initial amount borrowed) accrues interest. The lender must repay both the principal and the interest on the loan.
Term loans may be paid back over the course of a year, three years, ten years, or on another schedule, depending on the lender and loan type. The loan provides a lump-sum payout after approval, and the borrower begins repaying the loan immediately. (Interest also starts accruing on the principal instantly, so you’ll begin repaying interest immediately too.)
When should you consider a term loan?
Usually, term loans are good for businesses that need money all at once. So if your business needs a lump sum of money to fund a major purchase or to expand, then a term loan may be a good financing option.
Plus, since the value of a term loan may be higher than a line of credit, it can be an excellent choice for larger purchases and expenses.
Small businesses with an established history often have an easier time getting term loans. If you want to use one for your small business, keep in mind that a short-term loan might be available within just a few days, but a longer-term loan could take a week or two before being paid out after approval.
Additionally, long-term term loans tend to have better interest rates than short-term loans, though there are exceptions. A loan calculator can help you understand the real costs of taking out a loan, including how much your interest rate will end up costing over time. Using a calculator can help you ensure you’re taking out a term loan you can afford (meaning one you’re fairly confident you can repay), including the principal and expected interest.
What are lines of credit?
A small-business line of credit is a flexible line of revolving credit. In some ways, it’s similar to a business credit card, but it usually has a lower interest rate and more flexible repayment schedule (along with some other crucial differences).
Typically, a line of credit is more flexible than a term loan. Instead of getting a lump sum, you can borrow against the extended line of credit any time. You’ll only pay interest on the credit you use, which might not be the full amount of the line of credit. And again, unlike term loans, you don’t make payments on the line of credit until you borrow money.
A quality of lines of credit that many business owners appreciate is that they usually offer revolving credit. As you repay past debts, credit opens back up, which means you can pull more money as it’s needed.
Lines of credit usually offer less money than term loans. Typically, they start at around $10,000, though some lines of credit can go up to $1 million.
When should you consider a line of credit?
If you need money quickly (for instance, to run payroll or make a crucial purchase), a line of credit could work better for you than a term loan. Term loans typically take longer to get approved, so in an emergency where you need money fast, consider a line of credit.
Bear in mind that lines of credit typically have lower limits than term loans. As a result, lines of credit work better for smaller, one-time needs, while term loans work best for hefty business investments.
Small businesses looking to finance one-time or larger purchases may benefit from taking out a term loan that sets repayment fees and term limits upfront. Those looking to have flexibility in how they borrow may appreciate a line of credit, since they can borrow against it as needed.
Both options are good choices, and your small business may benefit from having both available to you for major purchases and expenses, emergencies, and other situations.
Would you like to learn more about term loans? Check out The Best Short-Term Business Loans in 2022 at Business.org.
Term loan and lines of credit FAQ
Which is better, a line of credit or term loan?
Term loans and lines of credit are both good funding options. The best one for you depends on your business’s unique circumstances and finances.
For instance, if you need to finance a large expense or a one-time purchase, a term loan might be a better pick because it gives you a lump sum of money to work with. But if your goal is to cover ongoing expenses or access to funds quickly, a line of credit may be a better choice.
Is a term loan a line of credit?
No, a term loan is not a line of credit. Instead, a term loan is a one-time, lump-sum payment while a line of credit is usually revolving, working (in some ways) like a typical credit card. You borrow from a line of credit as needed.
What is the difference between a loan and a term loan?
A loan is an umbrella term for many types of funding small-business owners use to support their businesses. Term loans and lines of credit are just two different types of loans.
What is the main difference between a line of credit and personal loan?
The primary difference between a line of credit and personal loan is that a personal loan requires fixed monthly payments and provides you with a lump-sum payment upfront. Lines of credit let you take out the cash you need and repay it on your own timeline (so long as you pay a minimum monthly payment).
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