Small businesses often encounter sudden cash requirements to run their day-to-day operations. Sometimes, they may need to make heavy investments in capital expenses, such as a purchase of real estate or equipment. In such cases, they look for outside financing to fulfill their cash requirements. They have a number of funding options from various sources such as banks, lending companies and private providers. This raises the need to understand each of these options thoroughly so that businesses can choose the one that is apt for them. Loans and lines of credit are two most widely used funding methods for businesses. Let us understand each of them and also the difference between the two.
What is a loan?
A loan is an amount of money that you borrow from a bank or a lender with the obligation to pay it back with a certain amount of interest at the end of a specific period of time. The amount that you will have to repay is known right from the outset as it is calculated by adding the principal to an agreed rate of interest for the term period. The amount is usually divided into installments that have to be paid from time to time. Loans are of various types such as secured and unsecured loans, mortgages and title loans.
What is a Line of Credit?
Besides loans, the other option is a line of credit, a financial tool which is used less often by businesses. With a Line of Credit, there is a borrowing limit that a borrower cannot exceed. He can borrow more money only after that amount has been paid back. The basic principle on which lines of credit work is that one line of credit has to be paid back before the borrower gets another line of credit. A majority if lines of credit do not have an end date.
How loans differ from lines of credit?
Loans and lines of credit are two different ways in which businesses can raise fund. Here are the differences between them:
A loan is a one-time, lump-sum extension of credit which is to be paid back in the form of regular installments. Lines of credit, on the other hand, are a borrowing limit that enables a borrower to use funds and re-borrow after the limit amount has been repaid.
When a business avails a loan, they get the loan amount right away and interest starts getting accrued on it there and then. On the other hand, when they get approval for a line of credit, they get the ability to borrow up to the credit limit right away, though it is up to them how and when they use the limit. Interest accumulation starts only when the business makes a purchase using the credit line.
Loans serve as a good option for specific purposes such as purchase of real estate. They are for a pre-approved purchase and the lender’s approval is needed before the loan amount is disbursed. Lines of credit are not typically meant for a specific purpose and can be used for a variety of needs. The business does not need to take the lender’s approval for every purchase it makes using it. They have a smaller minimum amount limit as compared to the upfront loan value.
Lines of credit serve as a highly flexible borrowing tool as compared to loans. While loans have to be paid back in the form of fixed monthly installments on specific dates, payments are flexible in case of lines of credit. This is because the dates and amounts of purchase are uncertain. At the same time, this makes repayment uncertain for the lender. For this reason, the rates of interest on credit lines are usually higher as compared to loans.
The closing costs for loans are higher than those for lines of credit.
Both the options have they own benefits and downsides. Also, the key features of these borrowing methods can be used as the basis of using them for your specific requirements. When it comes to making capital purchases, loans definitely make a better option because they give a lump sum amount right at the beginning. Lines of credit are a better option for the operational expenses as they are similar to credit cards. It is also possible to get Fast Line of credit by connecting with online lending service providers. The higher interest rate on this borrowing tool is justified by the fact that it has to be paid only of used.