Every business needs funding to start, build, or grow. But, when you think about finance, it is essential to contemplate your business’ financial state, which kind of business loans to opt for and how to go about it. Some have cash-on-hand while others (majority you may say) opt for small business loans and instant business line of credits. Both business loans and lines of credit may be used to support the capital requirements for various business objectives, such as acquiring new assets, increasing capacity, expansion into new markets, or making additional investments in building the business. However, as most of the financial products, both business loans and a line of credit serve their different purposes.
An organisation might use any of these instruments to support its financial requirements. Before we dig deeper into their key points, let’s have an overview of what these two terms mean.
Business loans, as the name suggests, are one-time capital amount lent to a business by a financial institution (e.g., an NBFC) or a private investor, to enable the organisation to support its capital requirements. In most cases, a lender would provide this loan on an agreed-upon interest, for a specific fixed or variable time. The rate-of-interest and the repayment terms are agreed between the business and lender, before the disbursement of the loan.
Business Line of Credit
A business line of credit, in simple terms, works just like the standard credit cards with a pre-defined credit limit, where a business has the option to obtain funds as per their requirements within the credit limit. The company may only utilise a part of their line of credit amount, and would then be liable to pay interest on the amount borrowed as per the terms defined in the borrowing contract between the business and the lender.
Now that we know what exactly these two types of small business loans, let’s move our focus onto what makes them different from each other.
Multiple uses V/S One-time Use
Small business loans are typically granted for a single business purpose. In most cases, a lender would expect a sizable portion of a loan to be paid off including interest before agreeing for a new loan requirement. However, the borrower can use the funds for any business activity as per his discretion, without informing the lender.
In case of a business line of credit, like a credit card, this can be used to draw up multiple rounds of funds within their overall credit limit. However, some lenders charge you a fee every time you want to withdraw funds. So look out for that clause before you make your withdrawals.
The lenders look at your business finances more carefully than your personal finances to consider you eligible for the business funding. Typically, your business needs to be up and running for at least two years and with a revenue of Rs. 10 Lakh for the previous year.
In order to be eligible for obtaining a line of credit, you need to maintain a good to excellent credit score. Other financial factors that decide your eligibility are your income and your debt-to-income ratio.
With business loans, you are entitled to pay monthly instalments. These monthly payments do not change from month to month for your entire term. Therefore, whether you utilise all your credit or not, your monthly instalment will not be affected by that.
However, with the line of credit, you are entitled to payment for the amount you borrowed. That said, in case you max out your credit limit, you won’t be able to take on any more credit to cover your expenses until and unless you pay it off first.
Closing Account Costs
The cost of closing a small business loan is always higher when compared to the line of credit. Though there may be few exceptions to this rule, the cost of closing a business loan will be 2-7% of your total loan amount. But the good news is that several NBFCs are emerging that do not charge you anything in case of pre-closure of the business loan after the payment of 6 EMIs.
On the other hand, the cost of closing a line of credit is very minimal. This is one of the most significant factors that affect the choice between these two.
Term of the loan (long term or short term)
Small business loans are usually better for long term debts that get paid off over a longer-term (generally, more than a year). Several short term business loans are also getting popular these days with new businesses emerging. One can get business funding for as short as a month with invoice financing.
Though the line of credit is considered best for short term due to unexpected increase in the working capital requirement, it is advised to use the line of credit only for most immediate and short term cash requirements due to the higher cost of funding associated.
Rate of Interests
The rate of interest that lenders charge for business loans can vary widely. But these are usually fixed and don’t change over time. This makes them more efficient borrowing tool over the long run when the lower long term funding spread offsets the higher initial funding costs. Sometimes, if you’re paying interest on a sizable loan, lenders can regularly offer you discounts for things like setting up an automatic payment.
In the case of the line of credit, the interest rate is usually lower but variable. Hence, if a startup poorly manages its line of credit and makes late payments and goes over the credit limit, interest rates can go very high. There might also be some additional charge as well. Besides, the borrower will still have to pay some fees even if he doesn’t take any credit from the limit during the entire tenure.
The difference in the ‘When.’
When you get, a business loan is different from when you get a business line of credit. A loan for business is usually for one specific purpose while the line of credit can be obtained before you need it. However, keep in mind, that a line of credit should be used in case of emergencies as it strongly affects your debt-to-income ratio and with that your credit report.
Fixed-term or Amortisation Period
Business loans carry with them fixed terms or authorisation periods. This is the reason the monthly payments on loans are usually higher than the monthly payments on the line of credit. However, you can always opt for other lending institutions such as NBFCs that are offering short-term or long-term business loans without collateral as well and most competitive interest rates.
Note: With a home equity line of credit, your home is serving as collateral. Therefore, in case you’re unable to repay the borrowed amount or any leftover interest, the lender can seize your home legally.
To summarise, both business loans and line of credit serve as two very different and beneficial funding avenues for supporting capital requirements for small businesses. An efficient business will use these tools with the right balance considerations so it can support both their short and long term capital requirements.