Line of Credit vs Term Loan: What are the differences and which is best for my business?
A line of credit gives a business access to credit when they need it with flexible repayment terms, similar to a credit card. Often a business will incur minimal to no costs if they have a zero balance on their line of credit. Lines of credit typically have floating interest rates based on Prime or another index that can change.
A term loan, on the other hand, provides a fixed amount of cash up front that begins accruing interest immediately, and the business will make monthly principal and interest payments until it is paid in full. Term loans often have a fixed interest rate for up to five years.
Which is better for your business depends on the purpose of the funds. Lines of credit are better used to fund short-term working capital needs such as buying inventory and repaying the line of credit once receipts are collected from a sale. Term loans are better suited for longer-term asset purchases such as equipment and real estate. It’s also common for businesses to utilize both lines of credit and term debt at the same time.
It’s a good practice to periodically discuss your credit mix with your banker to determine if adjustments should be made. For example, if your business has an outstanding balance on your line of credit, it may be time to “term it out” or convert the balance to a term loan and free up capacity on your line of credit. As your trusted advisor, your banker can guide you in the direction of your goals, helping you take advantage of interest rate trends and ensure your ability to fund opportunities as they arise.
Originally published in the Small Business Monthly’s Ask The Banker Column in October of 2024 by Pete Zeiser, President – Chesterfield Commercial at Midwest BankCentre.