What's Better A Business Loan or Line of Credit?

When applying for business funding, one question that many business owners have is; 'what is better a business loan or business line of credit?'

The best answer, although not the simplest, is that it depends on the use of those funds.

Business lines of credit are essentially short-term financing vehicles based on relatively known payback events like the conversion of assets. Business loans are more for long-term financing needs such as the purchase of durable assets where payback would results from either the deployment of such assets over a period of time (usually matched to the useful life of the asset) or from efficiencies established from the long-term use of the loan proceeds like increase revenue from expanded marketing events or the hiring of additional employees to satisfy demand.

Think about it this way. You would never go to your bank and inquire about their credit card products when you are in the market to purchase a home. Credit cards are essentially short-term financing vehicles that should be paid backed almost as soon as they are used - like when you receive your next pay check (essentially leveraging your next income event to get the capital you need or want today). Most credit card purchases are short-term in nature (like tickets to a show or a night out with the family - items that are consumed immediately without the ability to generate additional income) and thus should be matched to a corresponding loan product.

On the other side, it has been determined that most homes have 30 year plus useful lives. Thus, the loan you seek when purchasing a home should match the assets - thus 30 year term mortgage loans. This spreads out the payments of the loan over the life of the assets making such payments more affordable and allowing the borrower sufficient time to generate the income to repay the debt.

The same is true for business credit. Most business loans or lines of credit should be matched to the need of the business. Example, a retail home and garden business needs to purchase trees and shrubs now for the up coming spring season where it will sell the bulk of this inventory. There is no sense in applying for a long-term, say a 5 year loan, as the business will have to again make new purchases next spring.

A short-term seasonal business line of credit would be much better for this business. As the business begins to sell its inventory during the spring and summer seasons, the business will generate the cash flow to repay the advance against the line of credit - thus matching the sale of those assets to the cash flow or advance from the line of credit. Not only will this be cheaper in fees and interest for the business, but, the business will essentially use the assets purchased from the advance to pay for themselves as well as provide a profit for the business; to be used for cover other overhead or growth needs like salaries and marketing.

Also, as stated, matching the loan product to needs can save your business money. Think about this. A short-term $100,000 business line of credit for 12 months at 8% interest will cost the borrower $4,400 in interest. The same amount at the same rate for a 5 year business loan will cost the business some $21,700 in interest.

From the lenders side, one of the first things that a loan officer will ask is why you need those funds. The reason is that they want to match your needs with their products, not just to determine the value of the collateral or to see if your business is using those funds consistent with proper business practices, but to match the loan or line of credit with the potential payback period. If a banker approved a long-term loan for seasonal tree and shrub purchases, the bank's risk would sky rocket as the business would immediately sells those assets backing that line but does not have to use those proceeds to immediately repay the bank.

Business Loans or Lines of Credit can be secured or unsecured. Most business owners prefer unsecured but banks prefer to reduce their risk and secure these facilities should your business not be able to repay the loan, the bank could then sale that collateral and hopefully cover some of the lost principal.

Loans are usually secured by the assets they are used to purchase. Here's how. Your business needs a new piece of equipment to offer a new product line that is being demanded by your customers. That piece of equipment has a five year useful life and your bank approves a loan with a term of five years (matches the life of the asset). Now, your monthly payment is $1,000 per month but, after deploying the assets, your business increases its revenue by $1,500 per month. If this trend continues, your new asset will generate enough income monthly to pay for itself as well as provide additional revenue that the business can use for other needs.

Business lines of credit are essentially large credit cards. Your business can draw upon the line, pay some or all of it back, then draw again if needed. The main difference is that most business lines of credit are secured by some type of short-term assets (like described above with the retail home and garden business); assets that can quickly be converted into cash. Collateral could also include other inventory items or accounts receivables. Another difference is that you might have a credit card for life, but most business lines of credit have terms of one year (12 months) or less. In our home and garden example, it should not take that business more than the spring and summer seasons to sell that inventory and repay the line of credit. Thus, their line may only have a term of 6 months (three spring months and three summer months).

Now, come the following year, the home and garden business could easily apply for a new line or renew the existing line. But, most banking policies require that all lines of credit be paid to zero (paid in full) sometime in a 12 month period. This not only reduces the risk to the lender - not having an outstanding loan for long-periods of time - but also allows the lender to re-evaluate your business before approving or renewing your business line of credit as well as ensuring that your business repays the line with the assets that the line was used to purchase (again, making sure the sale of assets match the loan or line product).

Therefore, when seeking funding for your business, to save yourself both time and effort, you should first have a good understand of your needs as well as the use of banking or lending products. Finding the right financing vehicle for your business will not only meet your immediate capital needs but will save your business tons of cash in the long-run.

So, to answer the questions, "what is better?' It really depends on what those funds will be used for.

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