Small business owners looking to obtain financing will come across several options for borrowing funds. Two of the most common types of financing provided by banks, credit unions and alternative lenders are lines of credit and business loans.
To get the financing you need for your business to operate to its full potential, it is essential to understand the differences between a business line of credit and a loan.
Here’s what you need to know about these two financing sources to decide which one is right for you:
What is a business line of credit?
A business line of credit is a flexible solution for a business in need of financing: lines of credit offer short-term financing to businesses differently than a standard loan. Once approved, a business has access to a fixed amount of funding that it can withdraw from when needed. The company can then pay off the debt over time in a series of payments or immediately in a lump sum without any prepayment penalty.
There are many reasons why businesses use lines of credit. Some of the common uses include:
- Purchasing supplies
- Payroll coverage
- Increasing inventory
- Seasonal cash flow management
- Repair of equipment
- Adoption of new technologies
- Financing of marketing campaigns
- Improve creditworthiness
How does the line of credit work for a business?
If you apply for and receive a business line of credit, you will have a set amount of money that you can draw on for a specified period of time. During this period you can withdraw small amounts of money when you need it and pay interest and fees only on what you withdraw. In this sense, it’s a type of revolving credit, just like a credit card: you can pay the money back now and take out more later, or you can make payments over a longer period.
What is a business loan?
A business loan is a lump sum of money that a business can receive from a lender. In exchange, the company must repay this amount with interest over an agreed period of time. Businesses can use money from a business loan in many ways, including:
- Coverage of startup costs
- Purchase of real estate
- Renovation
- Recruit staff
- Purchase of equipment
- Purchase of inventory
- Grow the business
- Building creditworthiness
There are different types of business loans available depending on what best suits your business and its needs. Two of the most common types of loans are short-term and long-term business loans. You may need to repay a short-term business loan in a few months, while a long-term business loan usually has a term of between 3 and 10 years, but can have a term of up to 25 years.
Many businesses may turn to the U.S. Small Business Administration (SBA) to borrow money. These loans are also available through commercial lenders, although they are backed by the government. The SBA will pay the lender up to 90% of any losses due to the borrower’s default.
The two most common SBA loan programs are the SBA 7(a) loan, which you can use for general business needs, and the SBA 504 loan, which you can use for large purchases. The maximum loan amount for the 7(a) program is $5 million; the maximum for a 504 loan is $5.5 million.
How do business loans work?
After you receive a business loan, you begin repaying what you borrow plus a fixed or variable interest rate and any fees. Payments will typically be made monthly, but in some cases it is possible to make payments at weekly intervals.
The loans can be secured or unsecured business loans. You can use collateral, such as business equipment or inventory, to support a secured loan. If you can’t repay your secured loan, the lender can take the collateral as payment. An unsecured loan is not backed by collateral, so if you can’t repay the loan, the creditor could take you to court or sell your debt to a debt collector.
You can apply for a business loan from different types of lenders, including banks, credit unions or alternative lenders, which are completely online. Once you have a reason to apply for a loan and have determined the amount you want to request, you will want to research multiple lenders and determine which one offers the best small business loans for your purposes.
Some lenders are very transparent online about eligibility requirements, interest rates and fees. Other lenders may require a phone call or in-person meeting to speak with a representative. Once you find a lender, you need to go through the process of gathering the necessary documents and materials, including tax returns, bank statements, and business plan.
Main differences between business loans and lines of credit
Business loans and lines of credit are both tools that businesses can use to access funds. There are many differences between these two types of financing, including financing amounts and credit and income requirements.
Financing amounts
When you apply for a business loan, you receive the total amount all at once. You will also have to pay interest on the total amount once you receive the funds, so it’s a good idea to make sure you’ve decided exactly how much financing you’ll need — and that the loan corresponds to this amount. If you take out a larger loan than you need, you will pay unnecessary interest.
When you receive a business line of credit, a lender gives you access to a certain amount of money. You will only pay interest on the amount you draw from the line of credit, not the overall amount. In this case, you can apply for a larger amount of credit that you can use as a safety net for worst-case scenarios because you don’t pay interest unless you touch the funds.
There is no rule or standard for the total amount of funding you can receive from a business loan or line of credit. The amounts will vary depending on the lender. For example, OnDeck, one of the top small business lenders on Money’s Best Options list, offers business term loans from $5,000 to $250,000 and lines of credit from $6,000 to $100,000.
Another lender, Quickbridge, has business loans up to $400,000 but has no lines of credit available.
In general, business loan limits tend to be larger than lines of credit because businesses use loans for large-scale projects that may involve the purchase of property or equipment, while business lines of credit are used to cover operating expenses.
Credit and income requirements
To qualify for either type of financing, lenders will look at annual revenues, how long the company has been in business, and the company’s credit rating, although requirements will vary. While each lender has different qualification standards, getting approved for a business line of credit is generally easier than getting a loan. If you can’t get approved for a small business loan because of your credit, you may want to consider a line of credit.
Frequently asked questions about the credit and loan business line
How much loan can I get for a business?
The amount of loan you can get for your business and the price of the loan will depend on a number of factors, such as your business’s credit score, annual revenue, and the amount of time you have been in business. The purpose of the loan and its collateral will also affect the price. Some lenders will lend millions of dollars, but many small business loans are $500,000 or less.
How much business line of credit can I get?
A business line of credit can give you access to anything from a few thousand to a few million dollars, depending on the lender and whether your business meets the eligibility requirements. It is common for lenders to offer up to $250,000 if you qualify, and additional financing is available at some lenders. Lenders often have minimum requirements related to your business’s annual revenue, credit score, and time in business that you will need to meet to receive financing.
Should I Get a Business Loan or Line of Credit?
Business lines of credit provide flexible financing for day-to-day operating costs, such as covering payroll expenses or balancing seasonal gaps in cash flow. A business loan will come as a lump sum of money, which may be more useful for a major expense like new equipment.