Term loan vs. line of credit – How are they different?

A fixed term loan provides a lump sum of money that a borrower pays back with interest over an agreed-upon period. A line of credit, meanwhile, provides access to a sum of money that you can use as needed. Both options can provide you with funds in advance so that you can use them immediately. As you learn about what a fixed term loan and a line of credit are, understanding the pros and cons of both options will help you decide what type of financing to use in different scenarios.

How Do I Know Whether a Fixed Term Loan or a Line of Credit Is Right for Me?

To know whether you’re better off with a line of credit or a fixed-term loan, you need to assess your financial needs and goals. Look at your options carefully and make sure you determine the following before making a choice:

  • Why do you need financing?
  • When do you need financing?
  • How much can you afford to pay each day, week or month?
  • What type of financing do you qualify for?

Your credit score, financial situation, and overall health of your business will determine what type of financing you can get. Some types have more favorable terms than others, so it’s worthwhile to compare your options.

What Are the Benefits of a Fixed Term Loan?

A fixed term loan is usually the best option when you need an immediate influx of money to fund specific projects or purchases to drive your business forward.

In some cases, it’s easier to qualify for a term loan than a line of credit. If you have a lower credit score or haven’t had time to build your credit yet, a fixed term loan may be a good place to start. Keep in mind that the interest rate fluctuates based on your ability to repay.

If you struggle with managing your budget or want to simplify spending, a fixed term leaves you with a set, fixed payment each day, week or month. When you take out a fixed term loan, you’ll decide the term you will spend paying it off. This decision makes it easy and predictable to manage repayment. This planning can be convenient in complex financial situations, such as in high-cost purchasing opportunities or managing cash flow. If you keep up with all your payments, you’ll be done with the loan exactly when you anticipated.

What Are the Benefits of a Line of Credit?

line of credit provides you with continuous access to funds up to the total sum made available by your lender. Since you can use your Line of Credit as needed, you don’t risk paying interest on the money you’re not using as you might with a loan.

For example, if you take out a $10,000 loan for your business but only need $1,000 of it for the first year, you’ll have spent 12 months paying interest on $9,000 that you didn’t need yet. Using a line of credit instead, you’ll pay only for what you need.

With a line of credit, your payment amount depends upon the amount of credit you’ve used. You can eliminate this payment if you pay off the entire line of credit. If you’re good at staying on top of your budget, you can use a line of credit to make necessary purchases when you need them and manage your repayment as it suits your needs.

A line of credit is readily available as soon as you need it, making this option a wise one for emergencies. Suppose you don’t have cash flow to cover unexpected expenses. In that case, you may want to have a line of credit handy so that you can pay for these necessities immediately when needed. A business line of credit can help you keep the company moving forward even with a variable income. 

When Might You Consider a Fixed Term Loan vs. a Line of Credit?

A fixed term loan is a good option if you know exactly how much you need and want to have a predetermined repayment plan. Borrowers often use fixed term loans for needs such as:

  • Purchasing quick-turnaround inventory at a discount
  • Equipment, machinery and other tools for manufacturing
  • Technology and other office equipment, such as computer equipment, phone systems, copiers, furniture, and other similar technology
  • Real estate, office space expansion, renovations, and new construction

A line of credit is a better choice when you have short-term working capital requirements. They’re often used for short-term operating purposes and for more immediate revenue-generating activities because the business can access the funds as needed. Here are a few examples below:

  • Purchasing inventory
  • Repairing business-critical equipment
  • Financing a marketing campaign
  • Bridging a seasonal cash flow gap 

The Bottom Line

A term loan involves a fixed amount of funds, which the business receives in a lump sum once the loan is approved. Periodic payments are typically repaid over a defined period, or term, in a prearranged schedule of payments until the balance is paid in full. A fixed term loan could be a good fit for specific, high-cost purchases that will provide value to your business over a long period of time and will allow you to take advantage of unexpected opportunities.

A line of credit is fundamentally a credit limit a business can borrow against whenever they need it, often for a specified term. Your payment, and the interest is based upon the funds you use. Once repaid, the credit limit is available to be accessed again as needed. Choose this option if you’re looking for a steady stream of funds that can be used for day-to-day operating expenses and for long-term revenue-generating activities.

Making the right choice with your financial investments can save you thousands in the long run. It’s always wise to work out your budget carefully before you start spending money.