Business Line of Credit vs. Term Loan: Which Do You Need?

Use a line of credit for short-term needs and a term loan for long-term ones. A line of credit covers cash gaps you pay back within a year, like payroll while you wait on customers. A term loan pays for something that lasts for years, like equipment or a building, with a fixed payment schedule.

Bankers call this "matching." When the loan's life matches the asset's life, the payments fit your cash flow. When they don't match, good businesses get into trouble.

How each one works

	Line of credit	Term loan
How you get the money	Draw what you need, when you need it	One lump sum at closing
How you pay it back	Pay down as cash comes in; draw again	Fixed monthly payments of principal and interest
Interest	Only on what you have drawn; usually variable	On the full balance; fixed or variable
Typical length	1 year, then renewed	3 to 10 years (longer for real estate)
Best for	Payroll gaps, inventory, seasonal swings, receivables	Equipment, vehicles, remodels, buying a business

The most common mistake

The mistake I see most is using a line of credit to buy something long-term, like a truck or a remodel. The line fills up, it never pays back down, and now you have no room left when payroll is short. At renewal, the bank sees a line that has been maxed out for a year and starts asking hard questions.

Signs you need a line of credit

• Customers pay you in 30 to 60 days, but you pay your bills and payroll sooner.
• Your sales go up and down by season.
• You need to buy inventory before you can sell it.

Your cash conversion cycle tells you how many days of cash the business needs to float. That number is a good starting point for sizing a line.

Signs you need a term loan

• You are buying something you will use for 3 or more years.
• You want a payment you can plan around.
• You want to pay off expensive short-term debt and spread it out.

Many businesses need both

A healthy setup for a growing company is often a term loan for equipment and a line of credit for working capital, from the same bank. The line handles the swings. The term loan handles the long-term assets. See Chapter 4 on cash flow and Chapter 6 on every loan type.

Common questions

Is a line of credit better than a term loan?

Only for the right job. A line of credit is better for short-term needs like payroll gaps, inventory, and waiting on customer payments. A term loan is better for things that last for years, like equipment, a vehicle, a remodel, or buying a business.

What is a cleanup period on a business line of credit?

Many banks ask you to pay the line down to zero for 30 days in a row at least once a year. It proves you use the line for short-term needs, not as permanent capital.

Do you pay interest on an unused line of credit?

You pay interest only on what you draw. Some banks also charge a small unused fee or an annual fee to keep the line open, so ask about both.

How big a line of credit can my business get?

Banks usually size a line from your receivables and inventory. A common starting point is 75% to 80% of receivables under 90 days old plus 20% to 50% of inventory, then checked against your cash flow.