Many business owners don’t understand all the differences between a business loan and a line of credit. It’s important to understand these differences as you consider taking on debt. That’s because the two types of debt really vary, from the process of getting the money to how the debt impacts your credit rating.
Here’s a look at the basic differences between loans and credit lines, and how each debt type can be best used to help grow your business:
Business loans are a good way to obtain money you’ll need to pay back over a long period of time. Vehicle financing, property mortgages and equipment purchases are all examples of business needs that would be best financed through a loan.
One of the prime advantages of a loan is the interest rate is often fixed for the entire length of the loan. So if you buy a car and get a five-year loan at 5 percent, that will be your rate the whole way through. This makes it easy to budget for the payment amount.
When you’re looking for a loan, one key factor to research is the interest rate. Depending on your credit rating and the amount you want to borrow, you may be seeking a secured or unsecured loan. Expect to pay a higher interest rate for an unsecured loan.
Disadvantages of loans include one-time use — you can’t come back and take out a little more in a year or two. Your loan amount is set. Another issue: If you have gotten a loan secured by business equipment or vehicles, you may need to notify the lender if you decide to sell these assets. Your loan will also stay on your credit report for a long time, until it’s completely paid off. Even if you’ve paid off the vast majority of the money, the loan still shows as an outstanding debt.
Business loans need to be carefully structured. When done right, they may not appear on your personal credit report. This is why it’s important to consult with a business-finance pro when you go looking for a loan.
Business Lines of Credit
Business lines of credit are a good option if you need money on a more short-term basis. For example, a retail business may need money to purchase inventory, which it will then sell to customers within a few months’ time. You wouldn’t want to get a long-term loan that takes years to pay off on merchandise you’ll only have a short while. Other examples of good uses of a credit line include for working capital, to fund a short-term project such as a store remodel that will lead to higher sales, or to finance receivables awaiting payment.
By utilizing a credit line instead of a loan, you only pay interest on the money as long as it’s outstanding. When you sell the merchandise, you can pay back the funds immediately. With a properly structured business credit line, your borrowings won’t show up on your personal credit rating. But if the line of credit is reporting on your personal credit report, then your credit report would reflect that you actually have no outstanding borrowings on your credit line.
One key advantage of credit lines is that you only pay interest on your outstanding balance. As a result, your payment amount can go down over time, as you pay off your balance. You may also be able to set up your credit line so that you are only required to make interest payments, and can pay the principal off in a lump sum later.
Many business lines of credit do not use the interest rate to calculate the monthly payment but, rather, they only charge you a percentage of the outstanding balance. ?It will always be enough to cover the interest that accrued for the statement period. That’s good because it can keep the payment very low but it can also mean that your monthly payment may not be paying down very much on the principal amount.
With lines of credit, the interest rate isn’t always the most important factor to consider when comparing lenders’ offers. One might offer a lower rate, but structure the credit line so that your monthly payment is higher. If cash flow is a concern, that lower-interest line might not be the best choice. The other important concern is whether the credit line is going to be reflected on your personal credit report. A higher interest rate might be worth it if the loan won’t impact your personal credit.
Interest rates on lines of credit usually are variable and tied to some economic benchmark such as the Federal Reserve’s prime rate. Depending on how the economy is going, this can be a good thing or a bad thing.
You might get a credit line at a rate that gives you a payment you can afford. If the economy worsens, your interest rate might go down, making your payments lower and making it easier to pay down the principal balance. On the other hand, if the economy strengthens and interest rates rise, your credit line’s interest rate could go up, too. Now you might need more each month to make the interest payments.