Line of Credit vs Term Loan: Which Financing Fits Your Business?
Borrowing the wrong way is almost as costly as borrowing too much. A term loan and a line of credit solve different problems, and using one for the other's job either wastes interest or leaves you short at the worst moment. This comparison explains how each works, what they really cost and a simple rule for choosing between them.
Key takeaways
- A term loan is a lump sum repaid on a fixed schedule. A line of credit is a reusable limit you draw from and repay as needed.
- Match the financing to the asset: long-lived purchases suit term loans, short-term cash gaps suit a line of credit.
- Lines are flexible but usually carry variable rates, fees for unused balances and annual reviews that can reduce the limit.
- Arrange a line of credit while the business is healthy. It is hardest to get when you most need it.
Most small business financing conversations start with "how much can I borrow" when they should start with "what is the money for." A loan to buy a delivery van and a loan to cover payroll while a customer pays late are different problems. The van will earn money for five years, so spreading the cost over five years makes sense. The payroll gap will close in six weeks, so borrowing for five years would mean paying interest for years on money you no longer need.
That is the whole distinction in a sentence. Term loans fund things that last. Lines of credit fund things that pass. The rest of this article fills in the details so you can apply the rule to your own situation.
How a term loan works
A term loan gives you a fixed amount up front, which you repay in regular installments, usually monthly, over a set term. Each payment covers interest plus part of the principal, so the balance declines steadily until it reaches zero. Terms range from one year for short-term lenders to ten years or more for real estate and SBA-backed loans. Rates can be fixed or variable, and the loan is often secured by the asset it funds or by a general lien on business assets.
In the US, the Small Business Administration guarantees term loans made by banks through its 7(a) program, with loan amounts up to $5 million and terms that can stretch to 25 years for real estate. Online lenders offer faster, smaller term loans at higher rates. Many other countries have similar government-backed guarantee schemes for small business lending.
What term loans are good for
- Equipment, vehicles and machinery
- Buying or renovating premises
- Acquiring another business
- A large one-time investment such as a product launch or expansion
- Refinancing expensive short-term debt into a longer, cheaper structure
How a line of credit works
A line of credit is an approved borrowing limit that you can draw against whenever you need to, repay, and draw again. You pay interest only on the amount outstanding, not on the full limit. Most business lines are revolving, with a variable interest rate tied to a benchmark such as the prime rate, and are reviewed by the lender every year. Some lenders charge an annual fee, a draw fee or a fee on the unused portion of the line, and many require the balance to be paid to zero for a period each year to show the line is not being used as permanent funding.
Lines can be unsecured for smaller limits or secured by receivables, inventory or a blanket lien for larger ones. The SBA also guarantees lines through its CAPLines and SBA Express programs.
What lines of credit are good for
- Bridging the gap between paying suppliers and collecting from customers
- Seasonal inventory build-up ahead of a busy period
- Covering payroll during a slow month
- Taking advantage of a supplier discount for early payment
- A safety net behind the emergency fund
Common mistake
Using a line of credit to buy a long-term asset. The balance never gets paid down because the asset does not generate enough cash in the short term, the variable rate drifts up, and at the annual review the lender sees a fully drawn line and may cut the limit. The business is then left with no cushion and an asset it is still paying for on the wrong terms.
Side-by-side comparison
| Feature | Term loan | Line of credit |
|---|---|---|
| How you receive funds | Lump sum at closing | Draw any amount up to the limit, any time |
| Repayment | Fixed schedule of installments | Flexible; interest on outstanding balance, often monthly minimums |
| Interest rate | Often fixed; sometimes variable | Usually variable |
| Typical use | Long-lived assets and big one-time projects | Working capital and short-term gaps |
| Fees | Origination fee, sometimes prepayment penalty | Annual fee, draw fees, unused line fees |
| Lender review | At origination | Annually; limit can be reduced or line closed |
| Predictability | High: same payment every month | Lower: payments and rate vary |
| Best time to apply | When you have a specific purchase planned | Before you need it, while financials are strong |
What each really costs
Comparing the headline rate is not enough. A term loan's cost is easy to see: total interest over the term plus fees. A line of credit's cost depends entirely on how you use it. A line you draw for two weeks a quarter costs very little even at a higher rate. A line that stays fully drawn all year can cost more than a term loan at a lower rate, once unused fees and the variable rate are counted.
Worked example
Imagine a landscaping company that needs $40,000 of extra cash each spring to buy materials and pay crews before customers pay in early summer. The gap lasts about 90 days. Option one is a three-year term loan for $40,000 at a fixed 10%. Monthly payments are about $1,290, and total interest over three years comes to roughly $6,460, paid on money the business only needed for three months each year. Option two is a $50,000 line of credit at a variable 12% with a $150 annual fee. Drawing $40,000 for 90 days costs about $1,180 in interest plus the fee, roughly $1,330 a year, or about $4,000 over three years, and the limit is available again every spring. The line is clearly the better fit. Now suppose the same company wants to buy a $40,000 truck it will use for seven years. The term loan at 10% is the better fit, because the truck earns money over the whole term and the fixed payment is predictable. Rates here are illustrative; actual rates vary with the market and the borrower.
How to decide, step by step
- Name the purpose in one sentence. "Buy a van" or "cover the gap between paying suppliers and collecting from customers." If you cannot name it, you are not ready to borrow.
- Estimate how long the money will be tied up. Longer than a year points to a term loan. Shorter and repeating points to a line.
- Check whether the need recurs. Seasonal or monthly gaps favor a line. One-time needs favor a loan.
- Model the cost of each option on your actual usage. Use a spreadsheet with your real draw pattern, not the lender's headline rate.
- Consider what the lender will secure. A term loan may only need the asset as collateral. A line often takes a lien on receivables and inventory, which can complicate other financing later.
- Read the review and covenant terms. Lines often require minimum balances, periodic clean-up to zero and financial ratios. Loans may carry prepayment penalties.
- Apply before you are desperate. Lenders approve lines based on current financials. A strong year is the time to set one up, even if you leave it undrawn.
Pro tip
Many healthy businesses hold both: a term loan for the big asset and a modest line of credit as working capital insurance. If you can only get one right now, get the one that matches your most immediate need, and plan the other once the business has a stronger track record.
Choose a term loan when
- The purchase will generate value for years
- You want a fixed, predictable payment
- You are consolidating short-term debt into a longer structure
Choose a line of credit when
- The need is short-term and repeats
- You do not know exactly how much you will need or when
- You want a standby cushion that costs little until used
Getting approved
Lenders look at much the same things for both products: time in business, revenue, profitability, cash flow coverage of the proposed payments, personal and business credit scores, collateral and the owner's personal guarantee. Lines of credit, because they are revolving and reviewed annually, often require a somewhat stronger profile and more regular reporting. Prepare a current profit and loss statement, balance sheet, bank statements, tax returns and a clear statement of purpose. For a line, be ready to explain your cash conversion cycle and show that the line will be paid down from collections, not from new borrowing.
Outside the United States
Both products exist almost everywhere, sometimes under different names. In the UK and much of the Commonwealth, an overdraft facility on the business current account plays the role of a line of credit. Government-backed guarantee schemes for small business loans vary by country and change with policy. Interest rates, fees and collateral practices are set locally and move with central bank rates, so compare current offers from several lenders where you operate.
Before you apply
- Write a one-sentence purpose and the expected time the money will be in use
- Decide term loan or line of credit using the asset-life rule
- Build a cost model on your real usage pattern
- Gather financial statements, bank statements and tax returns
- Check your business and personal credit reports for errors
- Compare at least three lenders, including your current bank and an SBA lender if in the US
- Read collateral, covenant, review and prepayment terms before signing
Frequently asked questions
Can I convert a line of credit into a term loan?
Some lenders allow a drawn balance to be "termed out" into a fixed repayment schedule, especially when the line is up for renewal. Ask about this option before you need it, because it is useful if a short-term need turns out to be longer.
Is a business credit card a line of credit?
Functionally yes, a card is a revolving line, but at a much higher rate and with smaller limits. It suits small, short purchases paid in full. A bank line of credit is the right tool for larger working capital needs.
Does an unused line of credit cost anything?
Often a little: an annual fee and sometimes a fee on the undrawn portion. For most businesses the cost is small relative to the value of having funds available immediately, but confirm the fee schedule.
Will a new line of credit affect my ability to get a term loan later?
It can, in both directions. A well-managed line that is paid down regularly strengthens your credit profile. A line that is permanently maxed out, or a blanket lien on all assets, can make later lenders cautious. Keep the line for its intended short-term purpose.
Related reading
The bottom line
Term loans fund assets that last; lines of credit fund gaps that pass. Decide by naming the purpose, estimating how long the money will be tied up and modeling the cost on your real usage. Set up a line while the business is strong, and use a term loan with a fixed payment for anything you will still be using years from now. Rates, fees, program limits and guarantee schemes vary by lender and country and change with the market, so compare current terms before you commit.
