Business Loan or Business Line of Credit: Which Is Best for You?

A small business owner in her shop.

When small businesses need a cash infusion, they typically have two options: a loan or a line of credit. But what's the difference between a business loan and a business line of credit, and which is best for your business's needs? Here's a closer look at how both forms of financing work and the pros and cons of each.

What Is a Business Loan?

Business loans, sometimes called term loans, provide small business owners with a lump sum they must pay back over time, with interest. There are different types of business loans for different purposes. Long-term business loans are designed to finance long-term investments, such as purchasing or remodeling a building. They are generally for larger amounts and are repaid over three years or more.

Smaller, short-term business loans, often called working capital loans, can help with immediate capital needs, such as buying inventory or paying employees and rent during a slow season. Short-term loans typically have a six-month to 24-month term.

If you need to buy machinery or equipment, an equipment loan can help. These loans may be offered by banks, equipment financing companies or manufacturers. They use the goods you're purchasing as collateral.

Invoice financing is another type of loan that advances you money against your outstanding invoices, minus a fee.

How Do You Get A Business Loan?

You can get business loans from a variety of sources, including large commercial banks, community banks and direct online lenders. Established businesses can get loans backed by the Small Business Administration (SBA). Called SBA-guaranteed loans, these loans are made through approved lenders and range from $500 up to $5.5 million depending on which SBA loan program is used.

Bank loans and SBA loans have the most stringent requirements for loan approval. When approaching these lenders, you'll generally need to provide documentation including a detailed business plan; bank statements; contracts and incorporation documents; financial statements and financial projections. You may also be required to put up collateral—either business property such as machinery, inventory or accounts receivable, or personal collateral such as your home.

Most lenders will consider both your business and personal credit scores, so before you apply for a loan, get a copy of your business credit report and personal credit report as well as your personal credit score. Knowing your credit scores will help you identify which types of loans you're most likely to qualify for. The higher your scores, the more likely you are to be approved for loans with stricter criteria, such as SBA loans. If your scores are only fair, you'll probably have better luck approaching lenders that have looser criteria.

Business loans typically have fixed interest rates. The rate you can qualify for will vary depending on the loan amount, the type of loan, the lender and your business's creditworthiness.

What Is a Business Line of Credit?

Similar to a credit card, a business line of credit allows you to borrow up to a set limit. You pay interest only on the amount you've borrowed. You can choose to pay off the full amount every month or only the minimum payment, but just as with a credit card, any balance you carry will accrue interest. As you repay the money you've borrowed, you can draw on those funds again, up to your credit limit, without having to reapply or get reapproved.

Business lines of credit are designed for short-term financial needs. For example, a retailer might use a line of credit to buy extra inventory and pay seasonal employees during the holiday shopping season. You can also get a business line of credit to use as an "emergency fund," even if you don't have an immediate need for it. If an emergency arises, you can quickly access funds from the line of credit. If you don't draw any funds, there is nothing to repay.

Business lines of credit are available from banks, direct online lenders and even through the SBA, whose business line of credit program is called CAPLines. Business lines of credit are smaller than loans, generally maxing out at around $250,000. Many banks don't want to make small loans, so if you need $250,000 or less, a line of credit can be a good option.

How Are Business Loans and Lines of Credit Different?

Both business loans and lines of credits can provide the capital your business needs, but there are some important differences between them.

A business line of credit is revolving credit, allowing you to carry a balance that accrues interest. If you don't use the line of credit, you don't have to make any payments. Once you draw from the credit line, as long as you make the minimum payment each month, you can either pay your balance in full or pay whatever you can afford. (Just keep in mind that your unpaid balance will accrue interest.)

A business loan is installment credit. You receive a lump sum and make fixed monthly payments on it. You must start repaying the loan right away, whether or not you use the money immediately.

Unlike personal loans, most business loans are limited to specific uses. You can't use the proceeds of an equipment loan to pay your employees, for example. A business line of credit, however, can be used for any business purpose you choose.

Business loans are generally available in larger amounts than business lines of credit. However, loans are more likely to require collateral and generally have stricter criteria for approval.

Which Type of Financing Is Best for Your Business?

Is a business loan the right choice for your business, or would a business line of credit work better? The answer depends on several factors.

  • How much money do you need? Lines of credit typically top out around $250,000, so if you need more than that, a business loan is a better option.
  • What will you use the money for? If you have a specific purpose in mind, a loan designed for that purpose could be your best bet. If you'd like access to money with no restrictions on its use, you'll want to go for a business line of credit.
  • Do you want flexibility or predictability? If you crave predictability, a business loan with set monthly payments and a fixed interest rate can make it easier to budget for your business. If you want flexibility, a business line of credit that lets you adjust your monthly payment could be the answer. But keep in mind that lines of credit are more likely to have variable interest rates, and if you miss a payment, your interest rate could rise.
  • How good are your business and personal credit scores? Your creditworthiness will affect the amount of money you can borrow and the terms for which you'll qualify. Lower credit scores may make it harder to borrow larger amounts.
  • Do you need to build your business credit score? Getting a business line of credit, using it and paying it down can help a new business build a business credit score—and that can help as your financing needs grow with your business. Just make sure that the lender reports to the three major business credit bureaus: Dun & Bradstreet, Experian and Equifax.

If you're not sure if a business loan or line of credit is the best choice, there are other options for financing your business. In the end, carefully considering your financial needs, business track record and long-term goals will help you determine what type of business financing is best for you.