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Differentiating between Small Business Loan and Line of Credit

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Differences between Small Business Loan and Line of Credit

If you run a business, getting the right type of financing to use is key to growth and prosperity. When it comes to financing aspects of new businesses, various choices are available inclusive of small business loans and lines of credit. These two aspects of financing have key differences existing between them which investors should fully understand in order to make informed choices to satisfy their business needs.  

Small Business Loan vs. Line of Credit

A small business loan is a fixed amount of money offered by a financial institution to a new or growing company that is supposed to repay in installments by end of the term. Whilst a line of credit is a revolving account that allows borrowers to draw and spend some cash up to a certain limit, repay that cash (normally with interest) and then borrow it again.

Interest rates

Generally, the interest rate of a small business loan is different from a business line of credit interest rate. For a business loan, the interest rate is most probably high with a fixed rate while for a line of credit, the interest rate is lower and varies but tied to a particular interest rate.  Remember that with a line of credit, being late on payment or exceeding the credit line increases the interest rates. Conversely, if someone wisely manages his/her line of credit, they might be able to reduce their rates.

Payment

Both small business loan and line of credit expect installment payments, but terms of payment differ. The payment schedule of a small business loan will probably be a set of payments with specific set payment amount. You must accomplish this because you have only one amount lent from the start and the rate of interest is fixed. Payments are done either monthly, quarterly or annually. In some situations, your business loan might carry payments that are interest-only with the principal amount due at the end of your loan term.

With a business line of credit, the minimum needed payment amount may vary monthly depending on the drawn amount in the previous thirty days. Based on the existing loan agreement, interest-only might be due or the bank might need interest plus a part of the principal amount every month.

Terms or repayment periods

A small business loan might have a wide range of terms liable to the loan amount, the kind of collateral and business needs. Typical terms of the business don’t exceed 5 years unless a real estate collateralizes the loan. Whilst a line of credit, the line term can be 10 years with the bank given an option to call the line due annually. This gives the bank a chance to cancel that particular line of credit and expect the company to pay any undischarged balance if it prefers so.

Draw

The loan proceeds for a small business loan are issued after signing the loan documents. All loan proceeds involved are issued at once and the company owner won’t receive any extra or additional proceeds from that loan. For a line of credit, the company draws out a line that is similar to a credit card and has the eligibility of drawing amounts out as required. For example, if a business has a $20,000 line of credit, as much as required, it can draw on the line of credit on condition that the total of $20000 isn’t exceeded.

Fees

A small business loan has some involved fees to close the loan like credit fee, loan processing fee, and appraisal fee in case of any collateral. However,  for a business line of credit, some fees such as initial processing fees and also fees related to each draw made by the company (for the line of credit) are involved. For example, a bank might charge a $40 transaction fee every time a company wishes to make a draw from the line of credit. Because of this reason, together with a variable rate of interest, the bank tends to benefit more from the lines of credit.    

Which should you pick – small business loans or lines of credit? 

As with any requirement for a small company financing, the kind of funding you prefer should optimally meet the needs of your company as well as the particular financing need you are trying to fulfill. In most cases, business loans provide more merits like flexible repayments plans and variable financing sizes, thus for a short-term business loan, something such as a working capital would best fit your business needs. Be sure to weigh all your options as well as decide what’s best for your business before going for any form of business financing.  

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Sean Jacobson

I'm Sean, a former HR and business consultant providing you insights into the business world for Leader to Leader.

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