Quick comparison
- Term loan: one-time lump sum, fixed or variable rate, fixed repayment schedule (amortizing). Good for equipment, expansion, or fixed projects.
- Line of credit (LOC): revolving access up to a limit, draw and repay as needed, interest charged only on outstanding balance. Good for inventory, payroll, invoicing gaps.
Why the choice matters
Picking the wrong product increases cost and execution risk. A term loan locks you into payments that can strain cash flow if revenues dip. A line of credit can tempt overspending and carries renewal and unused-fee risk. In my practice advising small businesses for 15+ years, aligning the product with the timing and predictability of cash needs reduces financing cost and operational stress.
When a term loan is the better fit
Use a term loan when you have a defined project and can predict cash flow to support scheduled payments. Common use cases:
- Purchasing major equipment or vehicles
- Financing a leasehold improvement or facility expansion
- Buying another business or taking a long-term strategic position
Advantages
- Predictable payments make budgeting easier
- Often lower interest rates than revolving credit if secured
- Can stretch payments over several years to lower monthly burden
Trade-offs
- Less flexible: extra funds cannot be re-drawn
- Possible prepayment penalties or restrictions
- Requires proof of repayment ability; lenders commonly ask for collateral and a personal guarantee
Example calculation (simple amortizing loan):
A $100,000 term loan at 7% annual interest, 5-year term. Monthly payment = P * r / (1 – (1+r)^-n), where r = monthly rate (0.07/12) and n = 60.
Monthly payment ≈ $1,980. That predictability is useful if your revenue reliably covers fixed costs.
When a line of credit is the better fit
Choose a line of credit when cash needs are recurring, timing is uncertain, or you need a liquidity buffer. Typical use cases:
- Bridge payroll between client payments
- Buy seasonal inventory
- Smooth variable expenses in a cyclical business
Advantages
- Flexible borrowing and repayment; pay interest only on what you use
- Can be revolved and reused without reapplying if renewed
- Unsecured or secured options exist depending on lender and business profile
Trade-offs
- Variable rates are common, so interest cost can rise
- Renewal risk: some LOCs are short-term and require annual renewal
- Fees — maintenance, unused-line, draw fees — can increase cost
In practice, I’ve helped retail and service businesses use a $50,000 LOC to buy inventory during peak seasons rather than borrow $50K as a term loan and pay interest on the full amount year-round.
Key underwriting differences and eligibility
- Documents: lenders want bank statements, tax returns, business plan, and sometimes invoices or contracts. Online lenders may use bank-account data for automated underwriting.
- Credit profile: both products consider business and owner credit scores. Stronger scores and stable revenue produce better pricing.
- Collateral and guarantees: term loans are often secured by the asset being purchased; LOCs may be secured by receivables, inventory, or a blanket UCC-1 lien. Many lenders ask for a personal guarantee from owners of small businesses.
Authoritative guidance: the Consumer Financial Protection Bureau explains business lending basics and borrower protections (https://www.consumerfinance.gov/), and the U.S. Small Business Administration provides guidance on qualifying and loan types (https://www.sba.gov/).
Costs to compare (beyond stated interest rate)
- APR vs nominal rate: APR includes fees and is the better apples-to-apples measure.
- Origination fees: common on term loans and some LOCs.
- Annual/maintenance fees: typical for LOCs.
- Draw fees: small fee each time you borrow from an LOC.
- Unused-line fees: charged on the undrawn portion—reduce the benefit of “available” credit.
- Prepayment penalties: check the promissory note for term loans.
The CFPB and SBA both recommend requesting a fee schedule in writing before accepting an offer (see CFPB small business lending resources).
Tax and accounting notes
Interest on business loans is generally deductible as a business expense, subject to tax rules and limitations. Tax treatment depends on entity type and specific tax law (including limits that may apply to certain interest deductions). Always confirm with your tax advisor and check IRS guidance on business expenses (https://www.irs.gov/).
How to decide—practical decision framework
- Forecast needs for 12–36 months. If >80% of the cash need is one-time and predictable, favor a term loan. If needs recur or timing is uncertain, favor a LOC.
- Run scenario cash-flow tests: model low, mid, and high-revenue months and confirm you can cover minimum debt service on a term loan.
- Compare APRs, fees, and covenants. Ask lenders for an itemized fee schedule and compute APRs on expected draws and repayment schedules.
- Consider a blended approach: use a term loan for the capital purchase and a small LOC for working capital to smooth short-term gaps.
- Negotiate: lenders often have flexibility on fees, covenants, and collateral. Use competing offers to improve terms.
Steps to apply and what to expect
- Prepare documents: 12–24 months of bank statements, business tax returns, financial statements, a cash-flow forecast, and a description of how you’ll use funds.
- Choose lender type: local bank, credit union, online lender, or alternative finance company. Community banks can be more flexible on covenants; online lenders are faster but may charge higher rates.
- Review term sheet closely: check APR, amortization schedule, fees, collateral, covenants, maturity, and default remedies.
- Close and plan repayment: set up automatic transfers, maintain an emergency cushion, and monitor covenants.
For deeper reads on LOC structure and short-term financing, see FinHelp’s Small Business Line of Credit guide (Small Business Line of Credit: When to Use It and How to Qualify – https://finhelp.io/glossary/small-business-line-of-credit-when-to-use-it-and-how-to-qualify/) and our comparison piece on working capital lines vs term loans (Business Loans: Working Capital Lines vs Term Loans — Which to Use and When – https://finhelp.io/glossary/business-loans-working-capital-lines-vs-term-loans-which-to-use-and-when/).
Common pitfalls and red flags to avoid
- Ignoring fees: calculate APR and include all fees in your cost model.
- Over-borrowing: having too much unused credit increases fee exposure; borrowing too little can force expensive short-term fixes.
- Relying on a single lender: diversification gives negotiating power and backup if a line isn’t renewed.
- Missing covenants: technical defaults for missed financial covenants can accelerate loans.
When to convert a line of credit to a term loan
If you use a LOC repeatedly to fund the same recurring need (e.g., a large piece of equipment, repeated large purchases) or if your outstanding average balance is stable and predictable, convert to a term loan to lower interest cost and lock in a longer amortization. Many lenders offer a conversion or “term-out” option; ask for pricing and prepayment terms.
FAQs (brief)
Q: Can small or startup businesses get term loans? A: Yes, but startups often qualify more easily for shorter-term loans, microloans, or LOCs that consider bank deposits and revenue more than long credit history. The SBA has programs for certain borrowers (https://www.sba.gov/).
Q: Will a line of credit hurt my credit score? A: Having a line of credit can improve business credit mix; however, high utilization and missed payments will damage credit. Monitor utilization and payment history.
Q: Are interest rates negotiable? A: Yes. Bring competitive offers, a clean financial package, and be prepared to offer collateral or guarantees to improve pricing.
Final advice
Match product to purpose: use term loans for planned, one-time investments and lines of credit for flexible working capital. Build conservative cash-flow models, include all fees in your comparisons, and consider a blended structure when your needs include both capital projects and ongoing liquidity.
Professional disclaimer: This article is educational and not individualized financial advice. Evaluate offers with your accountant or financial advisor and consult lender disclosures. Authoritative resources include the U.S. Small Business Administration (https://www.sba.gov/) and the Consumer Financial Protection Bureau (https://www.consumerfinance.gov/).
