There are several key differences between a loan and a line of credit (LOC). Differences you need to go before putting yourself at the mercy of a bank loan manager or outside lender.
1. A loan is a one time deal
Once a loan is paid off, you have to reapply again if you need a cash-infusion in the future. A line of credit is always there to be drawn upon as needed, provided you keep it in good standing.
2. Loans are largely based on needs
When you need cash, you head to the bank or other creditor and apply. A line of credit, on the other hand, is something that you apply for before you need it, preferably when you launch your business, so that you’re not left scrambling when financial woes present themselves out of thin air (and they almost always do in the beginning).
3. Loans have set repayment terms
The terms are usually starting the following month after taking it out. And for the most part, you have to pay the exact same amount of cash out every month until it’s completely paid off. A line of credit can be more forgiving, depending on the bank you use, often requiring you pay a set interest rate on the amount outstanding and a small amount toward the outstanding balance itself. A $25,000 loan will typically require that you pay $200 – $500 more per month than that same amount owed on a line of credit – big difference in cost savings!
4. Loans have a hefty closing cost
Because they’re needs-based, loans usually come with a nasty 2 – 7% closing cost just to get the check cut. Banks know you’re desperate or you wouldn’t be asking for a loan, so they take the opportunity to squeeze a little more out of you. Since a line of credit is something most businesses get “just in case” they need it, most personal and business lines of credit have very little, if any closing costs associated with them.
5. Loans are great for making big purchases
Though they’re more expensive to pay off in the long run, loans are actually best for making big purchases such as equipment, building expansion or company relocation, hiring new staff, etc. Why? Because you really do want to leave your line of credit freed up for the unexpected expenses that can really put the hurt on your business such as receivables that need to be paid, new lucrative marketing opportunities that crop up, fax machines and printers that die, sudden sales that come up on items that can benefit your business, etc.
Keeping your balance low on a line of credit helps you to build more credit potential, offering bigger and bigger financial buffers to your business.
6. Loans are more expensive because of the fixed rates
Business loans have fixed rates that are more expensive than the lowest variable rate offered on your line of credit. However, when you abuse a line of credit with late payments or not being able to pay the minimum every month, the bank or lender will immediately increase your “variable” interest rate and likely sock you with a late payment fee or two as punishment.
On the other side of the equation, your credit will get better and the interest rate lower on your line of credit if you manage it well. Since bank loans have fixed interest rates, you’re at the mercy of the going rate when you apply, as opposed to an interest rate that reflects your ability to repay on time (such as what a line of credit can offer).
7. Banks don’t like giving either loans or lines of credit to SMB owners
This is a sad but very true reality, with the current approval rate for either somewhere in the 10% range at most North American banks. They just don’t have much faith in small businesses, in most cases for good reason. With 8 – 9 out of every 10 small businesses failing every year, who can really blame them? They have many more checks and balances to wade through, with the obvious main end benefit being they’ll charge you a much lower interest rate than an outside lender will.
Takeaway Advice for Small Business Owners Seeking a Cash-Infusion
As mentioned above, small business loans are for larger, long term purchases such as buying an expensive piece of equipment, purchasing real estate, or doing expensive renovations.
A line of credit should be used as a safety net for unexpected expenses such as a payroll shortage, vehicle repairs, or being late on your monthly building lease payment. And should be paid in full ASAP to continue building your credit limit and improve your variable interest rate.
Online lenders are becoming a preferred choice for SMBs who can’t get the banks to budge. Some offering rates as low as 5.9% for good borrowers. Learn more about this emerging industry, how to choose the right lender for you, and a list of recommended lenders with solid recommendations in this Forbes article:
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