Businesses can’t run without cash flow, or working capital, and there’s nothing more frustrating than needing money and not knowing where to get it. Each business is unique and there are a lot of options when it comes to securing funds. Two of these are business loans and lines of credit.
In this article, we’ll explain what each of these are and why they could be a good fit for your business. We’ll also go over some alternatives to both and how to increase your funding and build business credit without borrowing.
What’s the difference between a business loan and a line of credit?
A business loan is a sum of cash given to qualifying businesses that must be repaid over a given time period at a predetermined interest rate. A line of credit gives businesses access to a certain amount of money that they can draw on, repaying (with interest) based on the amount they withdrew.
The primary difference between the two is flexibility. With business loans you’re given the entire amount upfront and must repay in full, plus interest, while lines of credit enable you to withdraw the amount that you need over time and repay only that amount (plus interest).
We dive into both in more detail below.
What is a business loan?
A business loan is a type of loan that is used to finance a wide variety of business needs, such as buying inventory, expanding operations, or covering short-term expenses. The loan can come from a variety of sources, including traditional banks, credit unions, or online lenders. There are also several private lenders and companies that offer business loans.
How to get a business loan
It's important to carefully consider whether a business loan is the right option for your specific situation. You should evaluate your financial management strategies first to see if you have any other options. But if you're ready to apply for a business loan, here are the steps you need to take:
- Shop for a lender: There are a variety of lenders who offer business loans, including traditional banks, credit unions, online lenders, and private companies.
- Compare interest rates: It's important to compare the interest rates from different lenders to get the best deal.
- Research the terms and conditions: Not all lenders offer the same terms and conditions, so compare them carefully.
- Read the fine print: Make sure you understand all the details of the loan before you sign up. This includes the interest rate, repayment schedule, and any fees that may apply.
- Prepare your business plan: To increase your chances of approval, you'll need a solid business plan and good credit history.
- Complete the application form: This can usually be done online. The lender will require your personal and business information, as well as your credit history.
- Wait for approval: After submitting your application, you'll need to wait for approval. This process can take anywhere from a few days to a few weeks.
- Sign the loan agreement: This is a legally binding contract and it's important to read it carefully before signing. You’ll receive your funds after this is done.
Terms and rates
The terms of a business loan will vary depending on the lender, but typically they range from one to five years. One of the key advantages of a business loan is that it can help businesses access capital quickly and easily. This can be especially useful for companies that are just starting out or those that have been hit with unexpected expenses.
Interest rates vary by the lender. They can also be affected by the personal credit score of the primary borrower. Lenders look at the creditworthiness of the company, but someone needs to be the primary on the loan agreement. With smaller companies, that’s typically the business owner. Larger corporations may assign a corporate officer to be the point person.
What is a business line of credit?
A business line of credit (LOC), or credit line, is a type of loan that gives businesses quick access to cash. The terms of a line of credit are like those of business credit cards. The business can borrow up to a certain limit and must pay back the money within a certain period. Unlike a loan, a line of credit is reusable. Once the money is paid back, you can borrow again, up to your credit limit. The limit is set by the lender after they evaluate credit score, payment history, and business revenue.
LOCs are typically used by businesses when they need to make a large purchase and don't have the cash on hand to cover the cost, such as buying new equipment or inventory. They can also be used for expenses during tough times, like when sales are down, or the business is facing a cash crunch. The flexibility of a line of credit may be better than a loan in these situations.
There are two main types of LOCs: secured and unsecured. A secured LOC is backed by collateral, such as the business's inventory or equipment. With inventory financing, if the business fails to make payments on the loan, the lender can seize and sell the collateral to cover the debt. An unsecured LOC doesn't require any collateral and is typically more expensive than a secured LOC
How to get a line of credit
To qualify for a business line of credit, the primary applicant will need to have a good credit score and history, and the business must be profitable. The most common way to get a business line of credit is to go through a traditional bank, but there are several online lenders that offer LOCs. Shop around and compare rates before you decide on one.
Be prepared to put up some collateral. Most banks will want to see some proof that you're able to repay the loan, and they'll usually ask for collateral in the form of assets like property or equipment. If you can meet all these requirements, you should be able to get a business line of credit easily. Read the terms and conditions carefully, so you know what you're agreeing to.
Terms and rates
The terms and conditions of the LOC outline the allotted time to pay back any funds you take, what the monthly payments will be, and other fees that might apply. The interest rates for business lines of credit are typically variable rates that go up and down based on the prime rate. Both vary based on the lender, so do your research.
A variable rate of interest adds another dimension to this funding option that’s not present with a traditional business loan. Taking money from your LOC creates a variable expense, which can be challenging for financial planning and analysis. Traditional loans have fixed rates of interest, which is easier for accounting purposes.
Business loan vs line of credit: which should my business use?
The choice between these two funding options is usually situational. When you have a specific purchase in mind that requires a fixed amount of money, a business loan will probably work just fine. For project-based spending, like building a new wing or expanding a sales team, the line of credit gives you more flexibility. It’s a question of fixed versus variable amounts needed.
Of course, business isn’t always that simple. If it were, you could just use a corporate card to cover all expenses and not need to seek out extra funding. That’s only possible with some major changes, which we’ll go through below. Under normal circumstances, you may need fixed and variable funding to run your business. A loan combined with an LOC is a way to do that.
An example of this is a sales team expansion to boost sales for a new product. The materials cost of the product could be funded with a business loan because that’s a fixed expense. The sales team expansion is a variable expense because of turnover and training costs, so a line of credit is a better option to fund that. One is not better than the other. You need both.
Why spend management is critical to managing your debt
Getting a business loan or line of credit is just the first step. Much of the challenge comes after that. To be successful with your loan or LOC, you need sound spend management processes in place. That could include issuing your employees prepaid cards for business expenses or eliminating cost-intensive processes like expense reimbursement and free spending.
This is a challenge for many small business owners. Securing finance without a plan on how to spend it could put your company in a difficult position. Loans and lines of credit need to be paid back. Debt is something you want to take off your books as soon as possible. Managing cash outflows and expenses is one way to do that. Not borrowing in the first place is another.
Optimize spend and control your finances with Ramp
New business owners often ask the question, “Does a business credit card affect personal credit?” If they believe it does, they may choose to apply for a business loan or line of credit. That’s not a bad idea, but it’s also not necessarily the best path to profitability. Without optimizing your spending first, no influx of cash is going to put you in the black.
That’s where Ramp comes in. We answer the “charge card vs credit card” question that comes right after the personal credit inquiry above. Ramp issues charge cards. We track spending and automate reimbursement. Our dashboard gives you real-time insights into where your company money is being spent. That’s how you control your finances.
A funny thing happens when a company understands and controls its spending. The need for financing via loans and LOCs often goes away. You may not need to borrow money if you can more effectively manage the revenue you’re already getting. If you do need a loan, you’ll be able to use it more effectively. Visit ramp.com to learn more.