Aloan or a line of credit? Each fills a need
Q: I need some extra money for my business, but I’m not sure if I should take out a loan or get a line of credit. What’s the difference between the two?
A: A loan is for an immediate and specific need, such as a construction project. A line of credit is for shortterm, variable needs, such as seasonal expenses or a marketing campaign. So whether you go for a loan or a line of credit depends largely on why you need that extra money, although how you use it is not the only difference between the two.
Let’s say you are thinking of starting that construction project, and it will cost $50,000. To get a loan for that amount, you would have to explain to the lender exactly how you plan to use the money and demonstrate how your plan will help you increase your sales and profits so that you’ll be able to pay the money back. If you’re approved, the lender would give you the full $50,000 all at once. You’d pay closing costs of about 2 percent to 7 percent, and for a secured loan, you would need to put up collateral.
Then, once you have the money in hand, you would have to start paying it back, plus interest, right away. You would make regular monthly payments over the term of the loan, which would typically be two to six years, although a larger loan amount would have longer repayment terms. Interest would be at a fixed rate and relatively high.
Let’s say youwant to start that marketing campaign, which would cost $10,000, but youare also expecting additional seasonal expenses later this year. Though you only need $10,000right now, you could apply for a line of credit for $50,000 or other larger amount. If approved, you would have access to the full $50,000, but you would only tap into the funds for the $10,000 you need now. The balance would be held in reserve for the next time you need funds. In fact, the idea is to have the funds available when you need them without having to apply for a new loan.
Typically, the closing costs and interest rate on a line of credit would be lower than with a similarly sized loan, and the interest rate would be variable. You would only pay back the money you borrowed, which means your monthly payment amount could vary and even be zero if you pay it all back without tapping into the reserves. The full $50,000 would then remain available for you to borrow again.
For help determining your financing needs and an appropriate lending vehicle, contact the University of Houston Bauer College Small Business Development Center at 713-752-8400. Business advice is always free and confidential.