Line of Credit vs. Term Loan: Understanding the Key Differences
Compare business lines of credit and term loans on flexibility, costs, and use cases. Learn which financing structure matches your cash flow needs.
Lines of credit and term loans are fundamentally different tools. A term loan gives you a lump sum for a specific purpose. A line of credit gives you access to capital you can draw on as needed. Choosing the wrong one for your situation costs money.
Here is how to think about which structure fits your business.
Core Structural Differences
| Feature | Line of Credit | Term Loan |
|---|---|---|
| Structure | Revolving credit limit | Lump sum disbursement |
| Access | Draw as needed | Receive full amount upfront |
| Repayment | Pay down, draw again | Fixed payments until paid off |
| Interest Charged | Only on amount drawn | On full loan amount |
| Credit Limits | $10,000-$500,000 typical | $5,000-$5,000,000+ |
| Terms | 6-24 months, renewable | 1-25 years |
| Monthly Payment | Variable (interest + draw repayment) | Fixed amount |
| Best For | Ongoing/variable needs | One-time expenses |
The Cost Comparison
Lines of credit often have higher stated rates than term loans, but actual costs depend on how much you draw and for how long.
| Cost Factor | Line of Credit | Term Loan |
|---|---|---|
| Interest Rates | 10-25%+ (varies widely) | 6-30% (varies widely) |
| Origination Fees | 0-2% | 1-5% |
| Draw Fees | $0-$25 per draw (some lenders) | N/A |
| Annual/Maintenance Fee | $0-$500/year | None typically |
| Unused Line Fee | 0-0.5% on unused portion | N/A |
| Prepayment Penalty | Usually none | Sometimes |
Actual Cost Example
A $100,000 line of credit at 18% where you draw $30,000 for 3 months costs ~$1,350 in interest. A $100,000 term loan at 12% over 3 years costs ~$19,000 in total interest. The line costs less if you only need short-term access.
When to Choose a Line of Credit
Lines of credit work best for:
- Seasonal cash flow gaps — Draw in slow months, repay in busy months
- Inventory purchases — Buy inventory, sell it, repay, repeat
- Unexpected expenses — Having access without paying interest until you need it
- Bridge financing — Cover short-term gaps while waiting for receivables
- Payroll smoothing — Handle timing mismatches between payables and receivables
- Growth opportunities — Quick access to capital for time-sensitive deals
The Safety Net Strategy
Many businesses secure a line of credit just for emergencies. If you never draw on it, you pay nothing (or minimal fees). But knowing you have access provides peace of mind and prevents desperate decisions.
When to Choose a Term Loan
Term loans work better for:
- Major equipment purchases — Buy a $200,000 machine, pay over 5 years
- Real estate — Commercial property with 10-25 year terms
- Business acquisition — One-time purchase with defined cost
- Large renovations — Build-out with a fixed budget
- Debt consolidation — Combine multiple debts into one payment
- Expansion projects — When you know exactly how much you need
Real-World Scenarios
Scenario 1: Seasonal Retailer
Situation: You run a retail store that does 60% of revenue in Q4. You need $75,000 in August to stock up for holiday season.
Better choice: Line of Credit. Draw $75,000 in August, sell through inventory, repay by January. You pay ~4 months of interest instead of 3+ years of term loan payments.
Scenario 2: Restaurant Equipment
Situation: Your commercial oven died. Replacement costs $40,000 and you need it installed next week.
Better choice: Term Loan. Known amount, one-time purchase, predictable monthly payments. You could use a line of credit, but a term loan likely offers a lower rate for equipment.
Scenario 3: Marketing Agency Growth
Situation: You won a large contract but need to hire before client payments start. Payroll gap is 60-90 days.
Better choice: Line of Credit. Draw to cover payroll, repay when client pays. You only pay interest for the 2-3 months you need the money.
Why Not Both?
Many established businesses maintain both: a term loan for major assets and a line of credit for working capital flexibility. The two serve different purposes and can work together.
Example: A contractor has a $300,000 equipment term loan (trucks, machinery) plus a $150,000 line of credit for materials and payroll between project payments. Different tools for different needs.
Watch the Total Debt Load
Having both a term loan and line of credit means more total debt capacity. Make sure your cash flow can handle both if the line is fully drawn. Lenders look at your debt service coverage ratio across all obligations.
Qualification Differences
Lines of credit and term loans have somewhat different qualification requirements:
| Requirement | Line of Credit | Term Loan |
|---|---|---|
| Credit Score | 620+ (higher for larger lines) | 600+ (varies by lender) |
| Time in Business | 6 months-2 years minimum | 6 months-2 years minimum |
| Annual Revenue | $100,000+ for meaningful limits | Varies by loan size |
| Cash Flow | Strong consistent cash flow critical | Important but more flexible |
| Collateral | Often unsecured up to $100K | Often required for larger amounts |
The Decision Framework
Ask yourself these questions to clarify which product fits:
- Do I know exactly how much I need? Yes = Term Loan. No = Line of Credit.
- Is this a one-time expense or ongoing need? One-time = Term Loan. Ongoing = Line of Credit.
- How quickly will I repay? Under 6 months = Line of Credit. Over 1 year = Term Loan.
- Do I want predictable payments? Yes = Term Loan. Flexibility more important = Line of Credit.
- Will I need to borrow again soon? Yes = Line of Credit. No = Term Loan.
Ready to explore your options?
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Read more →Important Disclosure
Not Financial Advice: The information provided in this article is for general informational purposes only and does not constitute financial, legal, or professional advice. You should consult with qualified professionals before making any financial decisions.
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