When a growing business needs outside capital, the choice often comes down to two very different structures: a business line of credit or a term loan. Both can fund similar goals – hiring, inventory, equipment, or expansion – but they work in fundamentally different ways. Choosing the wrong structure can leave a business paying for capital it isn’t using, or without enough flexibility when needs shift.
How a Line of Credit Works
A business line of credit gives a business access to a set credit limit that it can draw from as needed, repay, and draw from again – similar to a credit card, but typically at a lower cost and with a larger limit. Interest generally accrues only on the amount actually drawn, not the full available limit.
How a Term Loan Works
A term loan provides a lump sum upfront, repaid in fixed installments over a set period. The full loan amount begins accruing interest immediately, regardless of how quickly the funds are used. This structure tends to suit a specific, one-time expense with a clear cost, such as a piece of equipment or a defined expansion project.
When a Line of Credit Fits Better
Businesses with recurring or unpredictable capital needs – covering payroll gaps, restocking inventory, or bridging seasonal slow periods – often benefit more from a line of credit, since they can draw only what’s needed and avoid paying interest on unused funds. This flexibility makes a line of credit a common tool for ongoing working capital management rather than a single large purchase.
When a Term Loan Fits Better
A term loan is often a better fit when a business knows the exact amount it needs and the expense is a one-time event, such as purchasing equipment, buying out a partner, or funding a specific growth initiative. Programs like an SBA loan are typically structured as term loans and can offer longer repayment periods for larger, well-defined capital needs.
Can a Business Use Both?
Many growing businesses use both structures for different purposes – a term loan for a major, planned expense, and a line of credit as an ongoing cash flow buffer. Funding sources generally evaluate each request on its own merits, so having one doesn’t automatically prevent a business from qualifying for the other, though total existing debt obligations are always part of the review.
Frequently Asked Questions
Is a line of credit more expensive than a term loan?
Not necessarily. Because interest on a line of credit typically applies only to the amount drawn, total cost can be lower than a term loan if the full amount isn’t needed immediately, though rates and terms vary by funding source.
Can a startup qualify for a business line of credit?
It’s possible, though most funding sources prefer to see some operating history and revenue before extending a line of credit, similar to requirements for a term loan.
Does using a line of credit affect eligibility for a future term loan?
It can factor into the review, since existing debt obligations are typically considered. A well-managed line of credit with a strong repayment history, however, can also demonstrate creditworthiness.
Fundmerica is a marketplace that matches growing businesses with the funding structure suited to their specific needs – not a single lender offering one product. Apply now to explore your options.