Business Loans: Working Capital Lines vs Term Loans — Which to Use and When

Quick primer

A working capital line (often called a revolving line of credit) behaves like a business credit card: you have a maximum limit, you draw when needed, and you pay interest only on the amount outstanding. Term loans deliver a fixed principal upfront that you repay with scheduled principal and interest payments over months or years.

Both have a place in a healthy financing stack. The right choice depends on timing (short-term vs long-term), cost (rate vs fees), collateral and how predictable your cash flow is.

Sources: U.S. Small Business Administration (SBA) guidance on business financing and IRS guidance on deductible business interest (SBA; IRS Publication 535).

How the two loan types work in practice

Working capital line (revolving):

• Structure: lender sets a credit limit and an availability period. You borrow, repay, and borrow again up to the limit while the facility is active. Typical terms include a one-year or multi-year commitment with periodic renewal.
• Pricing: interest is charged on the drawn balance (often variable rate tied to prime or SOFR) plus fees (unused-line fee, annual facility fee, or non-usage fee).
• Use cases: payroll gaps, inventory buildup for seasonality, bridging receivables, emergency repairs.
• Covenants and triggers: lenders commonly include liquidity covenants or financial reporting requirements for lines.

Term loan (installment):

• Structure: borrower receives the full principal at closing and repays through a fixed or variable-interest amortization schedule (monthly or quarterly) over a defined term (typically 1–10 years for small business term loans; SBA 7(a) and 504 loan terms vary).
• Pricing: usually a fixed or variable interest rate. Upfront fees and prepayment penalties may apply.
• Use cases: equipment purchases, real estate improvements, business acquisitions, refinancing long-term debt.

Authoritative resources: SBA finance pages explain standard term loans and lines; CFPB and IRS provide consumer/business protections and tax treatment references (SBA; CFPB; IRS Publication 535).

When to choose a working capital line

Pick a working capital line when your need is:

• Recurring or seasonal (e.g., retail inventory for holiday season).
• Unpredictable and short-term (e.g., unplanned repairs, timing gaps between invoices and collections).
• Best met by flexible access and interest-only costs on the draws rather than a fixed amortization.

Real-world signals that a line fits:

• Your gross margin and sales vary month-to-month and you need temporary cash for inventory buys.
• You frequently pay vendors faster than customers pay receivables and need a bridge.
• You prefer to avoid paying interest on a full lump sum for something you only need intermittently.

Pros

• Flexibility and only-pay-for-what-you-use pricing.
• Faster access once the facility is in place.

Cons

• Variable rates and ongoing fees can add up.
• Lenders can reduce or cancel lines at review time if financials deteriorate.

See our related guidance on lines vs term loans for growing businesses: Lines of credit vs term loans for growing businesses.

When to choose a term loan

Choose a term loan when you need a one-time, predictable funding amount for a capital purpose:

• Buying equipment, vehicles or large-scale software/licensing.
• Financing a commercial property build-out or acquisition.
• Refinancing higher-cost short-term debt into a structured schedule.

Real-world signals:

• You have a specific purchase with a clear useful life that matches a loan term (e.g., 5-year loan for a 5-year equipment life).
• You want fixed monthly payments for budgeting and may obtain a lower rate than a short-term revolving credit.

Pros

• Predictable payments and often lower long-term cost for capital projects.
• Easier to match debt term to asset life for better cash flow planning.

Cons

• Interest is charged on the entire principal; you can’t “pay down and redraw” as you can with a line unless the lender allows it.
• Upfront fees and possible prepayment penalties.

Related article: Business Term Loan.

Cost comparison and how to analyze total borrowing cost

Compare lines and term loans with a single framework:

1. Interest rate: fixed vs variable; compare the effective rate (include margin over benchmark).
2. Fees: origination, commitment/unused line fees, annual renewal fees, late fees.
3. Amortization impact: term loans have principal amortization that reduces interest over time; lines may remain outstanding and accrue interest.
4. Prepayment and renewal risk: term loans often carry prepayment terms; lines can be reduced or closed at renewal.

Example calculation (simplified):

• Line: $100,000 limit, you draw $40,000 for 3 months at a variable rate of 9% APR. Interest ≈ $900 (40,0000.093/12) + any fees.
• Term loan: $100,000 disbursed, 5-year amortization at 7% fixed APR. Monthly payment ≈ $1,980; total interest over term ≈ $18,800.

Decision rule: calculate the total cost for your expected draw period and compare it to the amortized cost of a term loan sized to the same requirement. Consider cash flow timing and flexibility needs.

Collateral, covenants and credit profile

• Collateral: lenders commonly take business assets (equipment, inventory, A/R) or blanket UCC-1 liens. Real estate or personal guarantees increase approval odds for both products.
• Covenants: lines often include liquidity tests (minimum cash balance) and reporting requirements; term loans may include debt service coverage ratio (DSCR) covenants for larger loans.
• Credit profile: lenders look at business revenue, cash flow, personal credit (for small businesses), time-in-business, and owner equity.

Regulatory and tax notes: interest paid on business loan interest is generally deductible as an ordinary business expense under IRS rules when the debt is ordinary and necessary to the business (IRS Publication 535). Seek a tax professional for application to your situation.

Practical decision checklist (15 items)

1. What is the primary purpose—short-term working capital or long-term asset purchase?
2. How long will you need the money? (days/weeks vs years)
3. Can you forecast cash flows accurately for repayment?
4. Do you need flexibility to borrow and repay repeatedly?
5. What is the total cost (interest + fees + prepayment penalties)?
6. How important are fixed monthly payments for budgeting?
7. What collateral are you willing to pledge?
8. What covenants can you reasonably meet?
9. Is a personal guarantee acceptable to owners?
10. How will the loan affect your balance sheet and ratios?
11. Can you get a better rate through SBA or other programs? (SBA programs may offer competitive terms for eligible borrowers.)
12. What happens at maturity or line renewal—rollover options or balloon payments?
13. Do you have seasonal patterns that call for a revolver?
14. Is there a tax or accounting reason to match loan term to asset life?
15. Have you compared offers and negotiated fees and covenants?

Common mistakes to avoid

• Borrowing a large term loan for a temporary cash shortfall—this increases interest expense.
• Relying solely on a line without contingency planning—lines can be reduced at renewal.
• Focusing only on headline rate—fees and covenants often determine true cost.
• Ignoring amortization schedule — understand how much principal is paid each month.

Two practical scenarios

Scenario A — seasonal retailer: needs inventory for holiday season. A $150,000 revolving line that is drawn during October–December and paid down in January keeps interest costs minimal and provides flexibility.

Scenario B — manufacturer buying a $500,000 press with a 7-year useful life: a 7-year term loan matches payments to asset life, reduces refinancing risk, and stabilizes monthly cash requirements.

Next steps and where to get help

1. Assemble 12–24 months of cash flow projections and three years of financial statements.
2. Request term sheets from multiple lenders and compare APR, fees and covenants.
3. If eligible, evaluate SBA 7(a) or 504 programs for lower rates or longer terms (SBA).
4. Consult your CPA about interest deductibility and your attorney on lien language.

Useful internal resources:

• Lines vs term guidance: Lines of credit vs term loans for growing businesses
• Term loan basics: Business Term Loan
• Cash-flow planning and short-term loans: How Short-Term Business Loans Should Fit into Cash Flow Plans

Authoritative resources: U.S. Small Business Administration (SBA.gov), Consumer Financial Protection Bureau (consumerfinance.gov), and IRS Publication 535 on business expenses and interest deductibility.

Professional disclaimer: This article is educational and not individualized legal, tax, or investment advice. Speak with your lender, CPA, or attorney to assess which loan structure fits your business and tax situation.