Clash of Cash: Small Business Loans vs. Lines of Credit

When starting or expanding a small business, one of the most critical decisions an entrepreneur faces is how to fund their venture.

Oftentimes, business growth is held back by a sort of “chicken-or-the-egg” scenario in which the business owner needs to hire or invest in a resource in order to grow, but they can’t afford the investment unless they have grown the business first. Financing can help you jump the chasm of being stuck in that loop.

Two popular financing options are obtaining a business line of credit from a bank and securing a loan. Each has its unique advantages and disadvantages, and choosing the right one depends on various factors, including the nature of your business, your financial health, and your long-term goals. It can get complicated, especially if you’re new to business ownership, but you don’t have to figure it out on your own. Instead, let’s navigate this together, shall we? In a future article, we’ll look at another type of business credit, using credit cards and how to do it right so you don’t ruin your credit score in the process - so stay tuned. But, first …

What exactly is a business line of credit? Think of it like a bucket that holds money. You can fill your bucket with money whenever you need it, up to a certain limit set by the bank or lender. You can take money out when you need to pay for things like new equipment, more inventory, or even to fix unexpected problems. Then, as you put money back into the bucket by paying it off, you can take it out again whenever you need it, as long as you don't go over the limit.

Here are some advantages of using a business line of credit:

• Flexibility: Business credit lines offer flexibility that loans cannot match. You can draw funds up to a certain limit, repay, and then borrow again, which is particularly useful for covering short-term cash flow shortages or unexpected expenses.
  
• Only Pay for What You Use: Unlike a business loan, where you receive a lump sum and start paying interest on the entire amount immediately, with a credit line, you only pay interest on the amount you've actually drawn down and used. This can result in significant cost savings if you don't need the entire credit line at once.
  
• Builds Business Credit: Regularly using and repaying your business credit line can help build your business's credit history. A strong credit history can make it easier to secure additional financing in the future at better terms.
  

Sounds good, right? Well, your money bucket has some disadvantages, too:

• Higher Interest Rates and Fees: Business credit lines often come with higher interest rates compared to traditional loans. There may also be additional fees, such as annual fees or transaction fees, which can add to the overall cost of borrowing.
• Variable Interest Rates: Most business credit lines have variable interest rates, which means the cost of borrowing can increase if interest rates rise. This unpredictability can make budgeting for repayments more challenging.
• Requires Strong Credit: Qualifying for a business credit line typically requires a strong credit history and financial performance. Startups or businesses with poor credit may find it difficult to qualify.

A money bucket probably sounds pretty nice right about now, but there’s another option that may be even better for you: a bank business loan.

A bank business loan is essentially a financial boost provided by a bank to help businesses fund their growth, cover operational costs, or finance major purchases. It’s a little like a giant booster rocket for your business.

You're ready to launch into the market and explore new opportunities, but you need a big burst of cash to make the necessary investments to get off the ground. The bank steps in (usually backed by the Small Business Administration), agreeing to give you the funds you need, but with a catch: you need to promise to repay the loan, just like you would with a home mortgage, but over a much shorter period of time. 

During the pandemic, the SBA made loans available at 3.75% interest payable over 30 years. Now, though, SBA loans are typically in the 7-10% range, and payable over a much shorter period. And, several private lending options have sprung up, like Quiq capital and Hum, with rates available in the 15-20% range, payable over 1-3 years.

Let’s look at the advantages of using a bank business loan:

Lower Interest Rates: Bank loans generally offer lower interest rates compared to business credit lines. For long-term financing needs, a loan can be a more cost-effective option.

Fixed Payments: Loans come with fixed repayment schedules, making it easier for businesses to budget and plan for the future. Fixed interest rates also protect against the cost increases that can affect credit lines if interest rates rise.

Lump Sum Financing: Loans provide a lump sum of cash upfront, which can be crucial for significant investments such as purchasing real estate, heavy machinery, or undertaking major renovations.

Of course, there are also disadvantages, some of which are:

• Less Flexibility: Once a loan is disbursed, you cannot borrow more without applying for a new loan. This can be a drawback for businesses that encounter unexpected expenses or opportunities that require additional funding.
• Early Repayment Penalties: Some loans come with early repayment penalties, making it costly if you decide to pay off the loan ahead of schedule. This can limit your ability to reduce interest costs by repaying early.
• Lengthy Application Process: The process of securing a loan can be lengthy and require extensive documentation, including business plans, financial statements, and personal financial information. This can be a significant hurdle for new or small businesses.

Phew! That was a lot of information. But now you know what business loans and lines of credit are, and you’re aware of the pros and cons of each. So let’s switch gears and discuss how to pick the right option for you.

The decision between a line of credit or a business loan largely depends on your business's specific needs and financial situation. What are your immediate and long-term priorities? If you require flexibility and anticipate needing funds on an ongoing basis for short-term needs, a business credit line might be more suitable. It offers the ability to manage cash flow effectively, though often at the cost of higher interest rates, so be aware of the trade-off.

Conversely, if you have a one-time, large-scale investment in mind, a loan might be more appropriate. Loans offer the advantage of lower interest rates and fixed repayment schedules, making them ideal for long-term financing needs. However, the lack of flexibility and potential early repayment penalties are important considerations.

In either case, it's crucial to carefully consider your business's financial health, the predictability of your cash flow, and your ability to meet repayment obligations. It's also wise to consult with a trusted advisor who can provide tailored advice based on your business's unique circumstances.

As your LIFTed Business Advisor, I’m here to serve as the trusted advisor you need to ensure you’re making the right financing decisions for your business. You don’t need to go it alone. Together, we’ll evaluate all your options in detail, considering your specific financial goals, then help you plan your future - with the funding you need.

Schedule a complimentary call with us today to get started.

This article is a service of Personal Family Lawyer®. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices with your business throughout life and in the event of your death. We also offer a LIFT Business Breakthrough Session™, which includes a review of all the legal, financial, and tax systems you need for your business. Call us today to schedule.

The content is sourced from Personal Family Lawyer® for use by Personal Family Lawyer® firms, a source believed to be providing accurate information. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking legal advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

We offer a complete spectrum of legal services for business owners and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer you a LIFT Your Life And Business Planning Session, which includes a review of all the legal, insurance, financial, and tax systems you need for your business. Schedule online today.