Business Line of Credit vs. Loan: Comparing Funding Options
This article contains general information and is not intended to provide information that is specific to American Express, or its products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.
Small business owners can choose from various funding solutions, but two of the most common are business loans and business credit lines. Depending on your needs and eligibility, either could help you manage your business’ financial health and fuel your long-term growth.
However, if you’re considering financing for your business, it’s important to understand the difference between a business loan and a business line of credit. Both options have pros and cons and will vary across lenders, and you want to make sure the financing type you choose aligns with your business’ needs.
How a business line of credit works
A business line of credit could be an attractive option because of its flexibility. It’s a revolving credit account, similar to a credit card, that gives you the option to repeatedly borrow money and pay down your balance. Your line of credit will have a credit limit — the maximum amount you can borrow at once. And you only pay interest on the amount you choose to borrow.
Some lenders offer a business line of credit with a draw period and repayment period. During the draw period, which could be one to several years, you can take out draws (loans) against your credit line. After the draw period, you can’t take additional loans and must repay the outstanding balance over a fixed repayment period.
Other lenders offer an ongoing business line of credit that doesn’t have a draw and repayment period. Instead, you repay each loan over a fixed repayment term, such as six or 18 months. Each of your payments goes towards the draw’s principal balance and the accrued interest or financing charges.
Having the option to borrow money when you need it could make a business line of credit a good fit for ongoing projects, working capital, and emergency expenses. Here are some additional pros and some cons to consider:
Pros of a business line of credit
- Use the funds for various business expenses: You usually don’t have many limitations on how you may use the money from a business line of credit as long as it’s used for business purposes. You could take a draw and buy supplies, inventory or equipment, or run payroll.
- Might not require collateral: A business line of credit may be unsecured, meaning you don’t have to offer any assets as collateral.
- Interest only applies to the portion of credit you use: You only have to pay interest on the amount you borrow.
- Ongoing access to funds: Once your account is open, you’ll have access to financing if an emergency or opportunity arises.
Cons of a business line of credit
- Risk of overspending: Having easy access to financing could lead some business owners to quickly use credit. Overspending could lead to cash flow issues, particularly if the purchases don’t directly increase revenue.
- Uncertain borrowing limits: You won’t know your credit limit until after you apply and are approved for a business line of credit. If you’re planning on financing specific purchases, you might not get approved for a high enough credit limit.
- Other fees may apply: Although you only pay interest on the amount you borrow, you could have additional draw fees, monthly or annual account fees, and inactivity fees.
How a business loan works
A business loan is a type of installment loan. You receive the entire loan amount upfront and then pay it back in regular installments. If you want to borrow additional funds, you’ll need to apply for a new loan.
The terms of a business loan may vary depending on the type of loan. Secured business loans — such as an equipment loan, vehicle loan, or commercial real estate loan — require collateral. Unsecured business loans do not.
Business loans tend to be a good fit when you have a specific purchase in mind. You might get approved for a larger amount with a business loan than with a business line of credit. This type of financing also often offers longer repayment periods, which could help decrease your payment amounts and minimize the impact on your cash flow. But you’ll want to consider the pros and cons.
Pros of a business loan
- Few limits on how you use the money for your business: Similar to a business line of credit, you can often choose how you want to use the proceeds from an unsecured business loan as long as the use is for business purposes. Some secured loans, however, are designed specifically to help business owners purchase a specific asset, such as equipment or a vehicle. The asset being purchased acts as collateral.
- Lump sum distribution: Business loans may offer more substantial loan amounts, which you could use to finance more costly purchases and projects. You don’t necessarily need to borrow the full amount if you’re approved for more than you need.
- Fixed rates and consistent payments: A business loan tends to have a lower rate than a line of credit, as well as a fixed interest rate and a set repayment period. As a result, you don’t need to worry about the payment amount changing and will know when the loan will be paid off.
Cons of a business loan
- Interest rates apply to the full amount: Interest starts to accrue on your business loan as soon as you receive the funds. The interest rate will also apply to the entire loan, even if you don’t end up needing the full amount.
- May require collateral: The business may need to pledge collateral to qualify for a secured installment loan. Some lenders may even ask for a UCC blanket lien, allowing them to claim any of the business’ assets as collateral.
- Inflexible repayment terms: Having a fixed interest rate and consistent payments can prove helpful at times, but it means you won’t be able to lower your loan payments to free up cash. As a result, you might need to pass on new opportunities or struggle with emergency expenses if cash flow becomes tight.
- May require a personal guarantee: Many small business owners need to sign a personal guarantee and promise to repay the loan if their business falls behind on payments.
Deciding between a business loan vs. line of credit
Choosing between a business line of credit and a business loan may come down to how you plan to use the money, and which one offers you the best terms. There are several questions you could ask yourself before determining which solution best suits your needs.
Why does your business need financing?
A business line of credit tends to work best for those who want continuous access to funds but don’t have an exact or immediate need, or when there’s an ongoing project that will require regular payments.
Business loans tend to work best for specific and more substantial purchases, such as supplies for an upcoming project or new piece of machinery. How you plan to use the money may also impact your eligibility and terms.
What’s your preferred repayment structure?
A business line of credit might offer low minimum payments, giving you the flexibility to adjust your payments based on your financial situation. A business loan will often have fixed payments.
Could you provide collateral?
For purchases where you’re using the financing to buy the collateral, such as a business vehicle loan, a secured business loan might be the best option.
If you have business assets or other collateral to offer, you could also consider a secured line of credit or secured business loan. You risk losing your collateral if you can’t afford the payments, but secured financing might offer higher credit limits and lower interest rates.
What is your financial eligibility?
Lenders will consider several factors when reviewing your application for an unsecured line of credit or loan. These commonly include your personal and business credit, how long you’ve been in business, and the business’ financial position. Many lenders also require the business owner to sign a personal guarantee — a pledge that you will repay the business’ debt.
It’s usually easier to qualify for a business line of credit than a business loan. However, if you can get a business loan, the loan amount may be higher than your credit limit on a business line of credit.
Choose the right funding for your business
Rates and terms will vary among lenders, so exploring your loan or line of credit options before making a choice might help you find the best solution for your situation. Depending on your needs, you may also consider using a combination of different loan types and financing.
American Express does offer the American Express® Business Line of Credit. Note that the American Express Business Line of Credit may have different eligibility criteria, terms and features from the lending products that are discussed above in this article.