- What is a small business loan?
- Small business loan vs. line of credit
- Which is better for building your business credit?
- Small business loan vs. line of credit: which is better suited for further growth?
Q: What is the difference between a small business loan vs. line of credit? Which choice is best for my business?
A: A loan is a lump sum borrowed all at once and paid back on a set schedule, while a line of credit is a loan that you can withdraw from as needed. The best choice for your business depends largely on what you’re hoping to achieve, but a long-lasting line of credit is beneficial for your business even if you don’t immediately need the money.
Owning a business requires careful planning, stringent research, and a comprehensive understanding of finances.
According to research from the Small Business Administration, a lack of capital or funding is one of the leading causes of business failure. Fortunately, modern businesses have access to several methods of acquiring funding.
Two of the most common ways for small businesses to access capital are small business loans and lines of credit.
Both of these methods have their pros and cons, and understanding the difference between a small business loan vs line of credit can help you know which option is the best choice for your specific company.
Building business credit is paramount to the long-term success of your business, and you can do this with both loans and lines of credit.
Modern businesses have even more potential sources for funding. Consider the Paycheck Protection Program that began during the height of the Covid19 pandemic.
During its run, approximately 5.2 million PPP loans were awarded to modern businesses.
While you can’t get PPP loans anymore, this just goes to show that taking advantage of the loans and lines of credit you have available is key to truly giving your business the best chance at long-term success.
In this article, we’ll be taking a closer look at small business loans, the difference between small business loan vs. line of credit, which option is better for building business credit, and which option is best for future growth in the modern digital world.
If you’ve ever searched “which is better, small business loan or line of credit?,” then look no further!
- What is a small business loan?
- Small business loan vs. line of credit
- Which is better for building your business credit
- Small business loan vs. line of credit: which is better suited for further growth?
What is a small business loan?
Before we get into the distinction between a small business loan vs line of credit, let’s explore both concepts in more detail.
In a perfect world, businesses would plan for economic downturns effectively – to the point where they wouldn’t need loans or lines of credit in the first place.
Paying attention to the direction of the market and other macroeconomic trends is often enough to keep your business afloat through times of financial strife.
Unfortunately, even the most careful planning won’t prevent your business from occasionally needing a little financial help.
Small business loans explained
A small business loan is a sum of money given to your business with the expectation that you will pay it back on time.
Almost all small business loans include interest rates and fees. This means you will end up paying more money than just the principal loan.
The exact interest rate and the fees included will vary depending on the loan provider and your business’s credit (or lack thereof). When you’re searching for a small business loan, there are a few key factors to keep in mind to ensure that you don’t get scammed.
Below, we’ve detailed a few of the things your business needs to be aware of when shopping for a small business loan:
- Interest rates
- The interest rate is the amount you’re being charged by the lender for borrowing money. Depending on the provider you use, you can be charged anywhere from a reasonable 3% up to an absurd 30%. Finding a healthy interest rate is paramount to setting your business up for success — and this is why shopping around to find the best rates is so important. Not to mention, the Fed’s hawkish policies mean that continuously rising interest rates might not be going anywhere.
- Hidden fees
- These might be handling fees, late fees, admin fees, annual fees, etc. Some of these fees aren’t an issue — especially if you how to avoid being hit by them. This become an issue when businesses don’t do their due diligence and incur hidden fees that they failed to factor in when accepting the loan.
- Repayment schedule/process
- Like the fees your loan might include, you need to be fully aware of how and when your loan will be repaid. This includes dates, times, and even time zones that you’ll need to adhere to avoid any extraneous fees.
- Lender’s reputation
- This is important. As you can probably gather from the varying interest rates, some lenders are better than others. Make sure you’re dealing with a trustworthy lender that is easy to find online. If you’ve ever asked the question, “What’s the best small business loan?” – then you’re on the right track.
Most loans will be provided by a bank or through the Small Business Administration, but they can also be provided by other institutions or wealthy investors.
If you don’t have any business credit or your business hasn’t been around for very long, a personal loan might be your only option.
Before moving on, let’s take a look at the differences between a small business loan vs. personal loan:
- Typically more expensive
- This is because people are inherently less trustworthy than a federally registered entity. Regardless of why personal loans are more expensive, the interest rates on these kinds of loans are almost always going to be higher than the interest rates on a business loan.
- Less capital
- Unless you have extreme personal wealth or several assets, the amount of accessible capital is almost always less with a personal loan.
- Shorter time frame
- Finding a personal loan that comes with anything more than a 5-year repayment plan is going to be difficult. Typically, most personal loans last between 2-5 years.
Small business loan
- Better interest rates
- Small business loans will typically have better interest rates than personal loans. Even if your business is new or has only decent small business credit, you’ll be hard-pressed to find a personal loan with cheaper interest rates than a business loan.
- More capital
- Small business loans will almost always provide more capital than traditional personal loans. This is because businesses have an inherent need for more capital than the average person or because the lenders that supply business loans are more confident in their clients paying them back.
- Longer timeframe
- While finding a personal loan that lasts for more than five years is exceedingly difficult, the same is not necessarily true for small business loans. Alternatively, microloans can last up to six years while other types of small business loans can last as long as 25 years.
What is a small business line of credit?
Now that you’re beginning to understand the distinction between a small business loan vs. line of credit, let’s dive into what a line of credit does for your business.
A line of credit is similar to a loan in that it is a sum of money offered to you by a bank that you must pay back.
That said, a line of credit differs from a loan in the sense that you don’t have to take the money all at once. Lines of credit exist for you to tap into if you choose to, but you don’t have to use them if there isn’t any reason to do so.
This is different from a loan in the sense that you can start a line of credit, withdraw no money, and simply keep the option open.
With a loan, you accept the full amount and must pay it back. With a line of credit, you simply use as much of the money as you want and are only required to pay back the amount used.
Lines of credit do carry interest, but only after a certain date.
If you take only what you need and pay it back promptly, you won’t incur additional charges for using the credit.
Which is better for your business?
Determining whether a small business loan vs line of credit is better for your business requires you to take an unbiased look at both options.
Below, we’ve created a detailed pros and cons list to help you decide which option is best for you:
Small business loans
- Tend to be bigger
- Help build substantial credit
- Easier to qualify for
- Easier to plan for
- Have to watch for hidden fees
- Predatory lenders
- Interest rates are typically higher
- The application process is tedious
Small business line of credit
- Are inherently safer
- Tend to be less expensive
- Also useful for building credit
- Always have cash on hand
- Quickly act on market opportunities
- Low limits aren’t very useful
- Bad faith lines of credit are common
- Requires discipline
- The impact on your small business credit might be unclear
Pros of small business loans
Tend to be bigger
Small business loans are inherently larger than small business lines of credit. This is because businesses must immediately start making payments on their loans, regardless of whether or not they’ve used the money.
Help build substantial credit
If you look at a loan for $50,000 and a line of credit for $50,000, the loan will help build your business credit more. Because a small business loan is often a large, lengthy agreement, loans are usually weighted more heavily in your small business credit calculations.
Easier to qualify for
Outside of organizations like the Small Business Administration and other large financial institutions, there are many providers of business loans. This means that there is almost always a way for your business to secure a loan.
Easier to plan for
If you have an ironclad goal in mind like an ambitious expansion for your business, then a loan is almost always the better choice. If you’re taking a loan out for a specific goal, you already know exactly what to plan for.
This can allow your business to create a detailed plan that explains exactly how the money will be spent and lays out the repayment schedule. Focusing on this kind of detailed planning helps ensure that your business is operating efficiently and flexibly.
Cons of small business loans
Have to watch for hidden fees
With the variety of lenders that businesses have to choose from, it’s not uncommon for some of these lenders to be a little bit shadier than others.
This might come in the form of predatory interest rates or absurd hidden fees.
Before signing off on a loan, make sure that you know about any possible prepayment penalties, credit insurance fees, late fees, application and origination fees, and anything else that might inadvertently cause you to spend money you weren’t expecting to spend.
If your business has spent hours, days, or even weeks looking for a lender, you might put yourself in the unfortunate position to be taken advantage of.
Remember, almost anyone can become a money lender. If you’ve been denied by countless institutions but finally found a lender with terms that are too good to be true, they probably are.
Business owners need to keep a watchful eye when they’re searching for business loans, because bad actors are everywhere.
Interest rates are typically higher
Any kind of lumpsum loan is going to carry a higher interest rate. When you’re looking at a small business loan vs line of credit, the loan is almost always going to carry a higher interest rate than the line of credit.
The application process is tedious
In addition to filling out lengthy forms, business owners that are hoping to secure a small business loan might find themselves waiting upwards of 2 months to hear back from their prospective lenders.
This means that if you’re short on cash and in a bad financial spot, you probably won’t want to wait 2-3 months to find out whether or not your application was accepted.
Pros of small business lines of credit
With a small business loan, your business is withdrawing a lump sum all at once and is responsible for immediately starting on a repayment schedule. With a line of credit, this isn’t the case.
A line of credit is inherently safer because your business is only borrowing what you need. Unless you’re dealing with a shady lender, there’s no way that you’ll be penalized for not using money.
Tend to be less expensive
Loans almost always include some kind of interest, even if you start paying the loan back as soon as you receive the money.
On the other hand, a line of credit allows you to avoid these extraneous interest charges. Prompt payment and only spending the money that you have to spend helps you to avoid paying anything beyond the amount you initially used.
Useful for building business credit
If you look at a small business loan vs. line of credit in equal amounts, the loan will have a greater effect on your small business credit.
That said, a line of credit is still a valid method of building business credit.
Always have cash on hand
With a line of credit, you always technically have cash on hand — especially if you’re managing the credit well.
This can help ensure that your employees are always paid, your suppliers are always happy, and that you’re providing the best service possible to your clients and customers.
Quickly act on opportunities in the market
When you have a line of credit at your disposal, you can quickly react to shifts in the market.
This could be as simple as making smart investments on market downturns or as convoluted as purchasing new real estate when things are looking bleak – it doesn’t matter.
What matters is that a line of credit allows you to take advantage of these kinds of chances.
The market is going to shift — that’s the nature of a free market. What separates successful businesses from unsuccessful ones is how quickly and flexibly they react to these shifts.
Cons of small business lines of credit
Low limits aren’t very useful
A line of credit won’t be as high as a traditional small business loan, and it uses the same business credit as a standard loan. Because of this, there’s a good chance that new businesses won’t qualify for large lines of credit.
Having access to extra capital is always helpful, but if you only have access to a few thousand dollars, there isn’t much you can do with that money.
Bad faith lines of credit are common
Thankfully, most states have predatory lending laws that prevent lenders from acting too egregiously.
Unfortunately, bad actors occasionally bypass these laws.
With extensive due diligence and proper vetting of lenders, you should be able to avoid predatory lenders or bad-faith lines of credit.
Just remember: If something sounds too good to be true, it probably is.
This aspect of a small business line of credit isn’t mentioned as often as the other negatives, but it’s still worth looking at.
Because you’re essentially creating a credit card for your business, you need to have some level of discipline to ensure that you’re not spending money on frivolous or useless expenses.
If you aren’t disciplined, you can quickly eat up your line of credit — putting your business in a terrible position.
The impact on your small business credit might be unclear
In some cases, you might not even be aware of how your line of credit truly affects your bottom line.
For instance, keeping your line of credit below 30% is typically the optimal usage for building business credit — but some creditors might want you to use less than 25% – which can lead to some confusion about the optimal way to use your business’s line of credit.
Small business loan vs. line of credit: which is better suited for further growth?
Small business loans and lines of credit are both important parts of building credit. Determining whether or not a small business loan vs line of credit is right for your business can help you get a head start as you build your company’s credit.
Loans are lump sums you borrow from a lender all at once.
Lines of credit are floating offers that you can use as needed.
Small business loan vs line of credit
Each business is different, and there’s no universal system that can help you decide between the two options.
The best way to determine whether or not your business needs a loan or a line of credit is to create a detailed plan that explains why you need the money, what the money will be used for, and how the money will be paid back.
Below, we’ve listed common reasons businesses seek out lines of credit or loans. Take a look to see if any of these reasons can help make your decision easier!
- New offerings
- Funding an acquisition
- Unexpected expenses
- Cheaper debt/improving prior loan terms
- Increasing inventory
If you’re hoping to expand your business, a small business loan is ostensibly the best decision. Expanding is expensive, and unless your business is specifically pivoting to a digital-first model — which a line of credit would work wonderfully for — a business loan is the best choice.
Researching new markets, hiring new employees, and creating marketing initiatives for these new markets takes a lot of money. With a small business loan, you can create a plan that details where all of the money will go and how you’ll start working on the repayment schedule.
If your business is planning on releasing new products or service offerings, a loan is probably the best bet. With the lump sum payment, you can pay for the research and development of your new offerings in conjunction with the marketing initiatives you’ll need.
For day-to-day operational expenses like ensuring payroll is handled, a line of credit is your business’s best bet.
Funding an acquisition
For acquisitions, a standard loan is almost always going to be your best bet. This is because you simply cannot qualify for a large enough line of credit to effectively purchase another business.
This depends largely on the size of your unexpected expenses, but if these expenses aren’t too unreasonable, you should opt for a line of credit.
Because you’re only using what you need, a line of credit is a great way to ensure that your business is never completely out of money.
Cheaper debt/improving prior loan terms
As your business grows and continues building business credit, consolidating your debt or looking for ways to improve your previous loan terms is a great way to make your money work for you.
Consider this scenario:
You started a business last year. You had no small business credit, so you were forced to apply for several different loans and credit cards to keep your business afloat.
Now, your business is doing well, but you’ve spent the money you were loaned. Across the board, you’re paying about 25% interest rates to make your monthly payments.
Instead of just biting the bullet and paying 25% in perpetuity, you can use your improved business credit to get one loan at a cheaper rate to pay off all of your previous debt.
Now, you still owe the same money, but you’re only paying one lender, and you’re only paying that lender 10% rather than 25%.
Keep an eye out for attractive loan terms because as you continue building business credit, opportunities like these will occasionally present themselves.
Increased inventory is a great way to ensure that you never run out of goods and that your customers are never left wanting.
Looking at the differences between a small business loan vs line of credit, the optimal strategy for increasing your inventory depends largely on how much you pay to produce that inventory.
If you’re just looking for some ordering flexibility and the ability to buy a few more units here and there, a line of credit will work fine.
If you’re looking to fill a brand-new order for a client, you’ll likely need to search for a loan.
At the end of the day, making the correct distinction between a small business loan vs. line of credit depends almost entirely on what your business hopes to accomplish.
It should also be noted that using a line of credit in conjunction with a business loan is a great way to capture the benefits of both options — especially because you don’t need to even use the money you’ve been awarded through your line of credit.
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Alliance Virtual Offices provides several tools for established entrepreneurs to use to better set their businesses up for long-term success.
Whether you’re hoping to achieve serious business growth or just want to secure some extra cash for day-to-day operations, Alliance Virtual Offices has the tools to help your business make the most of any loan.