Line of Credit vs Term Loan: Which to Choose?

Line of Credit vs Term Loan: Choosing the Right Option

When your business needs financing, two of the most common options are business lines of credit and term loans. While both provide access to capital, they work very differently and are suited for different situations. Understanding these differences helps you choose the right tool for your specific needs.

Overview: Key Differences

At a Glance

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How a Business Line of Credit Works

The Mechanics

A line of credit provides a pre-approved credit limit you can draw from as needed, similar to how a credit card works but typically with better terms.

Example Scenario:

• ●Credit Limit: $100,000
• ●You draw: $30,000 (for inventory)
• ●Pay interest: Only on $30,000
• ●Repay: $30,000 over time
• ●Available again: $100,000

Types of Lines of Credit

Line of Credit Terms

When to Use a Line of Credit

Ideal Scenarios:

• ●Managing cash flow gaps between receivables and payables
• ●Seasonal inventory purchases
• ●Covering payroll during slow periods
• ●Emergency reserves (available but unused)
• ●Flexible, recurring capital needs

Example Use Cases:

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How a Term Loan Works

The Mechanics

A term loan provides a lump sum of capital upfront that you repay over a fixed period with regular (usually monthly) payments.

Example Scenario:

• ●Loan Amount: $100,000
• ●Term: 5 years (60 months)
• ●Interest Rate: 10%
• ●Monthly Payment: ~$2,125
• ●Total Interest: ~$27,500

Types of Term Loans

Term Loan Terms

When to Use a Term Loan

Ideal Scenarios:

• ●Purchasing major equipment
• ●Business expansion or renovation
• ●Acquiring another business
• ●One-time large expense
• ●Refinancing existing debt

Example Use Cases:

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Detailed Comparison

Cost Comparison

Line of Credit Cost Example:

• ●Limit: $100,000
• ●Average utilization: $50,000
• ●Interest Rate: 12%
• ●Annual interest cost: ~$6,000
• ●Annual fee: $200
• ●Total Annual Cost: ~$6,200

Term Loan Cost Example:

• ●Amount: $100,000
• ●Interest Rate: 10%
• ●Term: 5 years
• ●Total interest: ~$27,500
• ●Average Annual Cost: ~$5,500

Note: Term loan has lower annual cost but less flexibility.

Flexibility Comparison

Cash Flow Impact

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Decision Framework

Choose a Line of Credit When:

✅ You need flexible, ongoing access to capital ✅ Cash flow varies month to month ✅ You're not sure exactly how much you'll need ✅ You want to minimize interest (pay only for what you use) ✅ You need emergency reserves available ✅ Your need is recurring (inventory, payroll gaps)

Choose a Term Loan When:

✅ You have a specific, one-time expense ✅ You know exactly how much you need ✅ You want predictable, fixed payments ✅ The expense has a defined timeline ✅ You're purchasing an asset (equipment, real estate) ✅ You want to lock in a fixed rate

Comparison by Business Need

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Hybrid Approach: Using Both

Many businesses benefit from having both:

Strategic Combination

Benefits of Having Both:

1. ●Right tool for each job: Match product to need
2. ●Preserves LOC capacity: Don't use LOC for fixed expenses
3. ●Lower total cost: Term loan for big purchases (lower rate)
4. ●Flexibility maintained: LOC available for surprises

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Qualification Comparison

Line of Credit Requirements

Term Loan Requirements

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Real-World Scenarios

Scenario 1: Seasonal Retailer

Situation: Holiday inventory purchase, will sell through in 4 months

Scenario 2: Manufacturing Expansion

Situation: New equipment to increase production, 7-year useful life

Scenario 3: Service Business Cash Flow

Situation: Projects pay net-60, need to cover expenses monthly

Scenario 4: Restaurant Renovation

Situation: $150,000 kitchen renovation, will increase revenue 20%

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Summary: Quick Decision Guide

If You Need...

Final Recommendation

Most businesses benefit from both:

• ●Line of Credit: For working capital flexibility
• ●Term Loan: For major purchases and investments

Start with whichever addresses your most pressing need, then add the other as your business grows and qualifies.