When should my business use a line of credit instead of a term loan?

Choosing the right financing—business line of credit or term loan—shapes your cash flow, interest costs, and flexibility. In my 15 years advising small- and mid-sized businesses, I’ve seen that the difference often comes down to predictability versus flexibility: use a term loan for predictable, one-time capital needs and a line of credit for variable, ongoing working capital requirements.

This article explains how each product works, typical eligibility and costs, practical decision rules you can use today, and common pitfalls to avoid. I’ll also link to related FinHelp resources so you can dig deeper into qualification strategies and loan options.

How each product works (quick overview)

  • Business line of credit: a revolving facility (like a business credit card) with a max credit limit. You borrow, repay, and re-borrow during the draw period. Interest is charged only on the outstanding balance; some lenders also charge an unused-line fee or annual fee.

  • Term loan: a one-time advance disbursed up front and repaid over a scheduled term with principal + interest (amortizing payments). Terms, rates, and covenants are fixed at origination.

Both can be secured (asset-based or real estate) or unsecured. Interest may be fixed or variable depending on the lender and product.

Sources: U.S. Small Business Administration (SBA): https://www.sba.gov and Federal Reserve Small Business Credit Survey: https://www.fedsmallbusiness.org

When to use a line of credit (practical triggers)

Use a business line of credit when:

  • You need short-term working capital to smooth payroll, seasonal inventory buildups, or irregular receivables.
  • Your cash needs are unpredictable in timing or amount and you want the option to draw only what you need.
  • You want a backup facility for unexpected expenses or to opportunistically buy inventory at a discount.
  • You prefer to avoid adding fixed monthly principal payments that reduce cash available for operations.

Real example from practice: a boutique I advised draws on a $50,000 line each holiday season to buy inventory, repays it in January, then keeps the line unused the rest of the year. That flexibility reduced their interest costs while preventing stockouts.

See our guide on qualifying for small business lines of credit: Small Business Line of Credit: When to Use It and How to Qualify.

When to use a term loan (practical triggers)

Choose a term loan when:

  • You need a defined lump sum for a capital project—equipment, real estate, a leasehold improvement, or a business acquisition.
  • You want predictable monthly payments to budget around and you aren’t likely to need ongoing, unpredictable draws.
  • The purchase will produce cash flow over time that covers principal plus interest.
  • You can secure better pricing or longer maturities by accepting a fixed amortization schedule.

Example from practice: a manufacturer financed a new press with a $250,000 term loan. The predictable payments matched the new revenue the machine generated, and a 5–7 year amortization fit the equipment’s useful life.

Related reading on structuring term loans: SBA 7(a) vs Community Bank Term Loans: Which Fits Your Business?

Key differences at a glance

Feature Business Line of Credit Term Loan
Purpose Ongoing working capital One-time capital expense or project
Availability Revolving (draw, repay, redraw) One disbursement; fixed repayment
Interest Charged on outstanding balance; often variable Principal + interest on full loan; often fixed or fixed portion
Payments Interest-only possible during draw period Amortizing principal + interest payments
Fees Origination, unused-line, annual review fees Origination, prepayment fees (sometimes)
Typical use case Inventory, payroll, seasonal spikes Equipment, real estate, acquisitions

Pricing, fees, and rate risk (what to watch for)

  • Interest: Lines are commonly variable index-based rates (prime + margin) and can rise with market rates. Term loans may be fixed or variable; fixed rates transfer rate risk to the lender.

  • Fees: Compare origination fees, commitment/unused-line fees, closing costs, and prepayment penalties. A low headline rate can be offset by heavy fees.

  • Covenants: Term loans—especially larger ones—often include financial covenants (minimum DSCR, leverage ratios). Lines of credit may require regular financial reviews or collateral refreshes.

  • Collateral: Secured lines and loans can use business assets, inventory, or real estate. Unsecured options exist but typically cost more and require stronger credit.

Regulatory/source notes: The SBA and bank underwriting practices evolve; always review lender disclosures and the loan agreement.

Eligibility and documentation (what lenders typically require)

Common lender requirements include:

  • Business and personal credit history. For small businesses, lenders often look for personal guarantors and credit scores. A 620+ personal/business score can qualify for many unsecured lines; stronger scores and financials improve access and pricing.
  • Time in business and revenue history. Many lenders prefer 1–2+ years of operating history; startup financing often needs alternative products or stronger collateral.
  • Financial statements, bank statements, tax returns, and cash-flow projections for term loans or larger lines.
  • Collateral documentation if the product is secured.

See our underwriting tips for lines of credit and term loans in this primer: Business Loans: Choosing Between Term and Line of Credit.

A short decision checklist you can use now

  • Is the need recurring or one-time? Recurring → line. One-time → term loan.
  • Can you tolerate interest-rate variability? If not, consider a fixed-rate term loan or a fixed-rate tranche.
  • Do you need to preserve cash flow flexibility? Line of credit reduces fixed principal outflow.
  • Will the asset purchased generate predictable cash to amortize a loan? If yes, a term loan is likely appropriate.
  • What are the total costs (APR + fees + covenants)? Calculate all-in cost over the expected life.

Common mistakes and how to avoid them

  • Mistake: Using a line of credit for large capital purchases and then carrying a high balance for years. Result: higher cost and volatile payments.

  • Fix: Use a term loan sized to amortize the purchase over its useful life.

  • Mistake: Choosing a term loan with a maturity that’s shorter than the asset’s useful life (creating cash flow pressure).

  • Fix: Match loan term to the expected cash generation timeline.

  • Mistake: Ignoring fees and covenants when comparing offers.

  • Fix: Request a full term sheet and model cash flows under different rate scenarios.

Frequently asked questions (brief)

Q: Can a business have both? A: Yes. Many businesses keep a line for working capital and a term loan for fixed assets. This mix controls interest costs while keeping flexibility.

Q: Which is cheaper? A: It depends. Term loans can be cheaper per-dollar for long-term capital because they lock a rate; lines can be cheaper when used short-term and paid down quickly. Total cost depends on usage pattern, rate type, and fees.

Q: How do I pick a lender? A: Compare community banks, credit unions, online lenders, and SBA options. Community banks often offer relationship pricing; online lenders can close faster; SBA loans offer long maturities and government-backed guarantees for qualifying businesses.

In my practice: a rule of thumb

I recommend clients adopt a two-tier approach: maintain a modest line of credit sized to cover one to three months of operating expenses for routine variability, and finance capital projects with fixed-term loans sized to the asset and expected cash flows. This reduces interest expense while keeping liquidity for surprises.

Professional disclaimer

This article is educational and does not replace personalized financial, tax, or legal advice. Loan terms and underwriting practices change over time. Consult a CPA, attorney, or your business banker to evaluate options for your specific situation.

Authoritative sources and further reading

Related FinHelp articles

If you want, I can create a simple Excel debt-model to compare two loan offers (line vs term) with your numbers—send your sample terms and I’ll show the cash-flow impact.