Quick comparison
- Line of credit: flexible, reusable borrowing up to a limit; pay interest only on what you draw. Best for seasonal cash flow gaps, supplier payments, and short-term working capital.
- Term loan: a single lump sum repaid over a fixed term with scheduled payments. Best for equipment purchases, expansions, or projects with predictable ROI.
Why this decision matters
Choosing the wrong product can increase borrowing costs, create cash-flow stress, or leave a project underfunded. In my work helping small businesses for more than a decade, I’ve seen firms take on the wrong financing and struggle with covenants, seasonal revenues, or balloon payments. Picking the right structure aligns repayment with how you earn and use the funds.
How each product works (plain language)
Line of credit
- Lender sets a credit limit (for example, $50,000).
- You withdraw any amount up to that limit, repay, and borrow again while the line is open.
- Interest accrues only on the outstanding balance; many lines have variable rates and periodic review requirements.
- Can be unsecured (higher rate) or secured by business assets or a personal guarantee.
Term loan
- Lender pays a lump sum (for example, $100,000) at closing.
- You repay principal and interest in scheduled installments over a defined term (e.g., 3–7 years).
- Rate can be fixed or variable; many term loans amortize principal so payments reduce the balance over time.
- Often used for one-time capital investments.
Typical costs and fee types
Both products have interest and fees, but the mix changes.
Line of credit fees:
- Interest on drawn balance (often variable, + margin over prime).
- Annual or renewal fees, unused line fees, draw fees, or minimum interest charges.
- Higher rates if unsecured.
Term loan fees:
- Interest on the full balance; if fixed, predictable monthly cost.
- Origination fees, closing costs, and sometimes prepayment penalties.
- Secured loans typically carry lower rates.
Example: cost comparison
Assume a business needs $50,000 for three months.
- Using a 12% APR line of credit and drawing $50,000 for 3 months: interest ≈ $1,500 (plus any draws/fees).
- Using a 5-year term loan at 8% amortized: monthly payments would be ~ $1,013 and three months of interest portion would be larger because the loan amortizes from a higher principal base—total borrowing cost is higher short term and commits the business to ongoing payments.
This shows lines are typically cheaper for short-term needs; term loans are efficient for long-term investments.
Eligibility and documentation
Lenders consider credit score, time in business, revenue, cash flow, and collateral.
- Lines of credit: banks and online lenders may approve businesses with 1–2 years of operating history and consistent cash flow; invoice lines or merchant-based lines can accept shorter histories.
- Term loans: lenders often prefer 2+ years in business with audited or well-prepared financials, clear projections, and stronger credit.
Common document requests: bank statements, business tax returns, profit & loss and balance sheet, business plan or use-of-funds memo, and personal guarantees for small businesses.
Tax treatment
Interest paid on business borrowing is usually deductible as an ordinary business expense, subject to rules and limitations (e.g., the business interest limitation under the tax code). Check IRS guidance on deducting business expenses and consult a tax advisor for your situation (IRS; see “Deducting Business Expenses”).
Sources: U.S. Small Business Administration on loan types and the Consumer Financial Protection Bureau on business loan basics provide excellent, up-to-date summaries (SBA, CFPB).
When to choose a line of credit
- You have unpredictable, recurring shortfalls (seasonal sales swings).
- You need working capital to purchase inventory or cover payroll between receivables.
- You want flexibility without committing to a multi-year payment schedule.
- Example: A retail shop that buys seasonal inventory and repays after peak season.
If you pursue this, negotiate renewal terms, fees on unused credit, and interest-rate caps where possible. Also consider secured vs unsecured options—the latter preserve assets but cost more.
For a deeper dive on setting up and qualifying for a line, see our guide to Business Line of Credit.
Business Line of Credit — FinHelp
When to choose a term loan
- You need capital for a discrete purchase with predictable returns (equipment, real estate improvements).
- You want fixed payments to simplify budgeting and match loan life to the asset’s useful life.
- You are refinancing high-cost short-term debt into a longer amortization.
- Example: A manufacturer buying a new machine that will increase output and revenue.
Term loans often offer lower rates when secured and are a better match for investments that create long-term value.
See our Business Term Loan overview for specifics on structuring and covenants.
Combined strategies and staging
Many healthy businesses use both: keep a smaller line of credit for working capital swings and a term loan for capital projects. This reduces the risk of using a term loan for variable needs and preserves borrowing capacity for emergencies.
Example staging:
- Use a term loan to buy fixed assets (equipment) with a 5-year amortization.
- Maintain a 6–12 month revolving line sized to cover seasonal payroll and inventory.
Covenants, collateral, and red flags
- Covenants: lenders may require financial covenants (minimum current ratio, debt-service coverage). Understand what triggers default.
- Collateral: lines and loans may be secured by accounts receivable, inventory, or other assets; personal guarantees are common for smaller firms.
- Red flags: aggressive teaser rates that reset, large prepayment penalties, onerous covenants, or unclear fee disclosures.
How to evaluate offers (step-by-step)
- Compare the annual percentage rate (APR) including all fees.
- Map repayment to expected cash flows—can you make payments in slow months?
- Check covenants and what counts as default.
- Ask for an amortization schedule for term loans and a sample draw schedule for lines.
- Negotiate fees, renewal terms, and collateral where feasible.
Common mistakes to avoid
- Using a term loan for short-term working capital — this can increase interest costs and reduce flexibility.
- Treating a line like free money; repeated draws without a repay plan can mask deeper margin problems.
- Over-borrowing based on optimistic forecasts; lenders can accelerate loans if covenants fail.
Short FAQs
Q: Can my business have both? A: Yes—many businesses keep both to match capital structure to needs.
Q: Which is cheaper? A: For short-term borrowing, lines are usually cheaper. For long-term financed purchases, term loans often cost less over the asset life.
Q: Are loan interests deductible? A: Generally yes for business interest, subject to tax rules—consult the IRS guidance and a tax professional.
Practical checklist before applying
- Build 12-month cash-flow projections.
- Gather 6–12 months of bank statements and 2 years of tax returns if available.
- Know your break-even cash flow and debt-service coverage ratio target (aim for DSCR > 1.2 for comfort).
- Decide acceptable collateral and personal guarantee terms.
Closing advice (from practice)
In my practice I recommend starting with clear use-of-funds and a repayment plan tied to project milestones or seasonal cycles. If you need bridge capital or seasonal top-ups, a line of credit prevents over-committing cash flow. If you’re buying an asset that will generate income for several years, a term loan usually matches the asset’s cash generation and keeps monthly payments predictable.
This article is educational and not personalized financial advice. For tailored recommendations, consult a lender or a qualified financial advisor and check current guidance from the Small Business Administration and the Consumer Financial Protection Bureau.
Authoritative resources
- U.S. Small Business Administration — Loans & grants: https://www.sba.gov/funding-programs/loans
- Consumer Financial Protection Bureau — Business loans resource: https://www.consumerfinance.gov/consumer-tools/business-loans/
- Internal Revenue Service — Deducting business expenses: https://www.irs.gov/businesses/small-businesses-self-employed/deducting-business-expenses
Disclosure: examples are illustrative. Rates and terms vary—always compare offers and request written fee schedules before accepting credit.
