By Jim Granat
If you’re an entrepreneur, you’ve almost certainly had to address a need for business funding at some point in your company’s lifespan. Nearly as likely is that those needs recur from time to time. The frequency and degree of your need for funding plays an important factor in determining the type that will work best for your business—not every small business loan works well in every situation. Let’s take a look at when a line of credit might be a better fit.
First, let’s define the two funding types. While I’m sure many of you are familiar with them, it doesn’t hurt to make sure we’re all on the same page.
Small Business Loan: A small business loan can be thought of generically as any type of loan or funding that is obtained by a business and used for business purposes. However in this article we’ll be referring specifically to what it is most commonly—a medium-to-long-term installment loan (or “term loan”) in which an approved sum of money is disbursed to a business with an agreement that it be repaid (plus interest and fees) in fixed or variable amounts over a pre-determined period of time. Typically, payments are made on a monthly basis, but bi-weekly payments are also fairly common. Loan amounts for this type of funding typically range from $5,000 – $500,000.
Business Line of Credit: A business line of credit is a more flexible type of business funding. A business is approved by a lender for a specific amount of credit that can then be “drawn” upon as needed. The repayment process is based on periodic statements in which a minimum payment (based on how much you’ve drawn plus interest) is necessary. The money you repay is then made available again for you to draw from your available credit. Small business lines of credit typically range from $10,000 – $250,000.
Now let’s take a look at several instances where a business line of credit may be more advantageous than a small business loan.
When You Have Seasonal Ebbs and Flows
All businesses experience ups and downs, but for seasonal businesses those ups and downs can be expected and planned for. Small business lines of credit are a great funding tool for these businesses. Unlike a term loan where payment amounts generally remain consistent throughout the year, a line of credit is perfect for giving you the money you need during the seasonal lulls while allowing you to pay it back once business picks up again.
When You Want to Build Credit
Because business lines of credit give you more control over the amount you borrow (and are often for lower amounts), business lines of credit can be better than term loans for building or repairing credit. Since your minimum payment is partially determined by the amount you’ve borrowed, you can make sure that the draws you requested are amounts you can comfortably repay. As you make regular payments, you’ll build credit history. The length of credit history in addition to the on-time payments will help to improve your business credit score, which should make it easier for you to obtain even more business funding (should you need it) in the future.
When You’re Just Getting Started
Taking on some debt to get your business started is practically a given, whether that’s through equity funding or debt funding. Lines of credit can be a great way to cover the cost of unforeseen expenses that require faster funds. Unlike equity funding, you can have the funds you need to grow your company without giving up any ownership in your business.
When You Need Cash on Demand
Unlike traditional term loans, lines of credit can provide you with cash on hand—with funds typically deposited into your bank account within one or two business days. Because the funds are available on-demand as cash, they’re better used for a wide variety of business expenses—rather than a term loan where the amount funded is typically tied to a specific project or purpose.
To summarize, business lines of credit are great for short-term financing needs; seasonal expenses, working capital needs, payroll, etc. Term loans are better for long-term investments that will take years to pay off, such as buying equipment at scale or renovating your facility. Of course, these types of funding don’t have to be mutually exclusive either. A business line of credit, for instance, could help your business build the credit necessary to obtain a term loan. The key is just to be mindful of which funding type is better for which business expenses, and to make sure you’re capable of repaying all debt in a timely and comfortable fashion.
Jim Granat is the head of Small Business Financing at Enova, where he helps small businesses take charge of their finances. He has worked in small business financing for over a decade and gained visibility into what small business owners need and expect.