Financing Options for Small Businesses: Loans vs. Lines of Credit

Business funding is getting harder to come by now that interest rates are rising. And with more rate hikes from the Federal Reserve scheduled into the end of the year, the cost of capital will continue to increase as the era of easy money fades. Now more than ever, it’s crucial for business owners to be mindful of their funding sources and secure the best possible option for their needs. Small business loans and lines of credit are two of the major funding sources for companies, but which best suits your needs?

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What is a Small Business Loan?

For small business owners, borrowing money is usually an important step in getting a company off the ground and fueling growth. Businesses need financing for a wide variety of things and often a small business loan is the best way to solve a capital shortfall. Small business loans are similar to personal loans in that they can be fixed or variable rates with different terms, lengths, and fees attached.

Small business loans can be issued by a bank, through the Small Business Administration (SBA), or by an alternative lender. Traditional banks tend to have stricter requirements and may not be ideal for startups that lack enough financial history. 

The length and amount of the loan will depend on the needs of the business. Short-term loans can have term lengths anywhere from six months to two years and usually provide relief for immediate business needs like payroll, inventory, or necessary repairs and upgrades. 

Longer-term loans are also available for business owners thinking about investing in the company for the long haul. With terms starting at three years or longer, these loans are geared more toward capital purchases like equipment, property, or long-term business investments. 

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How is a Line of Credit Different From a Small Business Loan?

Not every business owner will need a lump sum of cash all at once. Small business loans offer owners all the funding upfront and require the money to be repaid over time. A small business line of credit is a different funding option, which opens up a capital source that the owner can tap as needed. A business line of credit is a revolving source of money that can be replenished and retapped over time. 

Here are some of the critical differences between the two:

• Interest and Fees: A small business loan will have a fixed or variable interest rate that is applied to the full amount of the loan. A revolving line of credit, on the other hand, only charges interest on the money withdrawn by the owner. For example, if you’re approved for a $100,000 revolving line of credit and draw $75,000, you would only be charged interest for $75,000. Interest rates and fees will vary depending on your credit and business history.

• Repayment: Business loans have a fixed repayment schedule that business owners are aware of prior to receiving the money. A line of credit does not have a fixed schedule since owners can tap the funds at will and only need to repay what they take out.

• Funding limits: The amount of capital granted for each type of financing can vary from lender to lender. When working with a lender, you can ask which product they suggest. Or, if you indicate the amount of cash you need and provide some information about your business finances, the lender can select a product that best suits your situation. 

• Approved Uses: For a business loan, many lenders will ask you to specify what you plan on using the cash for. They may charge a higher rate for non-approved uses or prevent a business from different uses entirely. A business line of credit may be more flexible when it comes to approved uses.

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Common Uses for a Business Loan

Business loans can be used to cover short- or long-term expenses. It provides upfront capital for businesses to expand their operations and increase revenue. Since a business loan is a single, lump sum of cash issued all at once, business owners often have a specific expense in mind for the funds. Here are a few common uses of business loans:

• Equipment and Machinery - The equipment needed to run a business is often expensive, especially if you’re in the manufacturing sector. Think about all the different machines needed to manufacture something like a printer or computer: soldering equipment, machine presses, lathes, sanders, and more. These expensive items often can’t be paid for out of pocket and loans come in handy when making large capital purchases.

• Land and Leases - If you’re just starting a business that requires office space or a building to operate in, you may need to make a hefty down payment. Down payments on land and leased real estate are often reasons business owners utilize loans.

• Paying Down Debt - If business conditions improve, an owner may be able to pay off high-interest debt using a loan with much friendlier terms. Paying off an 8% loan with a 5% loan can free up cash for other business needs.

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Common Uses for a Business Line of Credit

A business line of credit is more geared toward ongoing financing needs, akin to what you’d use a credit card for. However, many services and bills cannot be paid with a credit card, which makes a business line of credit very handy for certain company owners. Lines of credit also usually have higher limits than credit cards. Here are a few examples of how a line of credit might be used:

• Inventory - Businesses often use a line of credit to purchase inventory. Since the amount of money withdrawn is flexible, lines of credit are especially beneficial for seasonal businesses. It allows businesses to align their inventory purchases with the ebbs and flows of the business. 

• Payroll - There’s no business without employees and making sure they’re paid on time is one of the most crucial jobs of a business owner. A business line of credit can be a great solution during slow periods when it’s difficult to meet payroll needs.

• Marketing - Marketing plays a huge role in scaling a business. While some marketing expenses are more predictable, most fluctuate. For example, the cost to advertise is usually higher during busier times of year, like the holidays. Event sponsorships can be a large one-time marketing expense. The flexibility to take advantage of these opportunities can have a big impact on business growth. 

• Everyday Business Operations - A business line of credit often doesn’t come with a list of required uses, making it ideal for covering any cash flow hiccups in the day-to-day operation of the business. Think office equipment, vendor and bill payments, or other expenses to run the business.

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How Do You Qualify for a Small Business Loan?

Small business loans are provided by traditional banks, online or alternative lenders, and the federal government via the SBA. Loan amounts can vary from as little as $5,000 to as much as $5 million, depending on the size and credit worthiness of the business.

Some factors lenders may consider are credit history (for both you and the business), income statements, balance sheets, and other financial documents. Some lenders will offer friendlier terms if collateral like inventory or equipment is used to back up the loan.

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How Do You Qualify for a Small Business Line of Credit?

In order to qualify for a business line of credit, you’ll still need to provide financial information like credit score and business history. Offering collateral such as inventory or equipment may increase the amount you receive or help you secure friendlier terms. Terms and amounts will depend on the lender. With so many options available, business owners will often speak with multiple lenders before deciding which is best for their business. 

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Explore Your Funding Options with Aion

Aion can assist your small business with financing for a wide range of expenses. With term loans and lines of credit up to $2 million, Aion can provide the working capital business owners need to pay bills, purchase inventory, invest in marketing, and much more. Apply today to see which financing solution is the best fit for your small business.