Xan Myburgh is the CEO + Co-Founder of Backd Business Funding, a leading alternative financing solution.
Funding is a problem that every business must navigate as it attempts to grow. As a dedicated business owner, you likely know these struggles better than anyone. So what is the right move for your business, a line of credit or a regular loan? The best place to start is learning the difference between the two, and as CEO and co-founder of a company serving business clients with finance options, I’m intimately familiar with the attributes of both.
What Is A Line Of Credit?
A line of credit is a common funding option. A lender assigns a credit limit similar to a credit card that you are allowed to spend. This means that the borrowed amount can be used, repaid and then used again. Once you have this new line of credit, you are able to spend it on whatever you feel is most necessary for your business, such as:
- Purchasing new inventory or refilling current stock.
- Financing a new marketing strategy.
- Extra cash for seasonal fluctuations.
Generally, a line of credit is used when you need extra money for short-term expenses. This is why they have higher interest rates and lower average dollar amounts.
It is important to note that there are two types of lines of credit, secured and unsecured. To acquire a secured line of credit, your business will need to pledge specific assets as collateral to “secure” the funds. As lines of credit are normally short-term liabilities, the lender will ask that the collateral be a short-term asset like inventory.
Getting an unsecured line of credit is harder to acquire as it does not require collateral. To ensure that the lender has some security, the lender will need a lien or personal guarantee that payments will be made. A strong personal credit score may be required to get an unsecured line of credit.
What Is A Regular Loan?
Loans are non-revolving, large lump sums of money only issued once. You are then required to make principal and interest payments until the debt is fully paid off. Loans can also be both secured and unsecured. A traditional loan from a bank, for example, will always require some form of collateral.
Another downside to regular loans is that they can only be used for a singular purpose. That means if you get a loan to help with payroll, you won’t be able to use a cent of that money to buy inventory or fix equipment.
What Are Lines Of Credit Advantages And Disadvantages?
Pay For What You Need: A line of credit allows your business to have a maximum balance that is the highest estimated cost you will need to cover everything. Then, you will only pay interest on the amount you need and use.
Boost Cash Flow: A line of credit is a simple way to ensure that even during a down month or quarter, you are still able to pay everything on time. Businesses that are heavily impacted by the seasons often make the most out of this type of financing.
Work Around Your Timeline: With a line of credit, you can withdraw as much as you need at any point in time. Then, you have the ability to pay it back on your own timeline with interest (this varies).
Improved Credit: To get more favorable loans, you will often need a higher credit score for the application. A great way to build that score is by establishing a positive credit history with a business line of credit by making payments on time.
Interest Rates: I mentioned this earlier, but one of the most significant drawbacks to a line of credit is how high the average interest rates are. These rates are variable, and depending on the term length, credit amount and your credit score, it could be more than 25% in some cases.
Lower Limits: Another common pain point businesses associate with lines of credit is that there is a much lower limit compared to a traditional loan through a bank, for example.
While the advantages of a line of credit can appear to outweigh the disadvantages for its specific use cases, this does not stop businesses from rightfully worrying about some potential pitfalls.
Are There Risks In A Line Of Credit?
There are risks associated with all types of loans. I suggest all businesses watch out for hidden risks lenders won’t warn you about, such as a monthly maintenance fee. While the initial cost to secure a line of credit is relatively low, the variable interest rates that rise with the larger market can end up being more expensive than anticipated. One other risk that often gets overlooked is not making your minimum payments. This can lead to the line being closed entirely and liability for your business or for you as an individual. So, how does a line of credit get paid back? Because you are borrowing in increments, you will repay that original amount, then borrow again as long as the line remains open.
One way to avoid some of the risks associated with a business line of credit is to go through a reliable and trustworthy alternative financing source. Many alternative lenders offer a wide range of credit limits. Some alternative lenders will also tailor business financing to your needs by adjusting payment options for daily, weekly or semimonthly payments. The lines of credit also offer unlimited terms and feature a soft credit pull that will not affect your credit score.
What’s Easier To Get, A Regular Loan Or A Line Of Credit?
The real question is whether a traditional business loan is easier to get than a line of credit. In this comparison, the line of credit comes out on top. As with the many advantages laid out above, one of the best reasons to choose a line of credit over a regular loan comes down to the flexibility it grants you, which can be ideal for the inconsistent nature of smaller businesses. Smaller or newer businesses could struggle to make any progress on securing a bank loan but could have relative ease acquiring a line of credit.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.