Line of credit versus business loan: What entrepreneurs need to know

A line of credit gives your business the ability to access a quick infusion of cash when you need it. Payroll, buying inventory and paying for machine repairs are three examples of instances when it makes sense to tap into a line of credit. Bank loans are often used more for the long-term investment of your business, for things like equipment, vehicles or a facility.

When you’re starting up a business, you’re more than likely pulling together multiple resources to get things up and running. Grants, crowd-funding, investments from family members, and loans all come together to make your opening day possible. When it comes to bank loans versus a line of credit, they’re alike in that they may come from the same lender and you pay monthly installments with interest. But if you make the mistake of treating a line of credit as interchangeable with a loan, you could end up stranded without a source of cash flow when you need it.

Learn more about using crowdfunding as a part of your start-up strategy by reading our recent blog here.  

The following will walk you through how a line of credit differs from a traditional bank loan, and how you can make these tools work for you.

Line of credit: Knowing the basics

A line of credit is a great tool to help you launch and grow your business, and here’s a quick look at how it works.

• • A line of credit is a flexible loan arrangement with the bank. It works much like the credit card in your wallet.
  • Unlike a bank loan, you can use it on anything you need to keep the business going.
  • You can borrow as much as you need, anytime you need it, as long as it doesn’t exceed the loan cap. Then you make installment payments, plus interest.
  • When you need a quick cash flow solution, a line of credit is meant to eliminate that continuous borrow-repay cycle.

When might you use a line of credit? Let’s say a big order comes in. You may not have the cash on hand to purchase all the supplies for the order and staff your lines, but a line of credit would give you access to the cash until you get paid.

When a bank loan might be better than using a line of credit

Need to replace a small piece of equipment and you have enough on your line of credit to cover it? Or maybe you'd like to purchase a used vehicle. Putting these on your line of credit is easier than going to the bank and getting the loan. But that doesn’t mean you should and here’s why.

Remember the big order example? Once you got paid, you could use the money to repay your line of credit for inventory and wages — and hopefully have some profit to cover costs. When it comes to equipment purchases, a line of credit could put you at risk.

For starters, ask yourself how soon you could repay the loan. If you’re thinking of using the line of credit to purchase collateral, you can make the argument it would help you operate your business. But it’s highly unlikely to make that significant contribution to your profits so you could repay the loan in a short time. (Unless you have solid, compelling data that supports this, in which case, it’s worthy of consideration.)

If you're unlikely to repay the line of credit quickly (say, less than 18 months), you may want to look at other funding sources, including grants or loans, and here's why: 

• The first consideration is interest rates. Loan interest is fixed, so once you sign on, the interest you pay stays the same for the life of your loan. As we indicated earlier, interest for a line of credit is variable, which can add another wrinkle to forecasting your expenses. Fixed costs make life easier.
• The other thing to think about is your future cash flow needs. As we’ve all experienced in the year 2020, nothing can be taken for granted. Even if you’re one of those rare entrepreneurs who seldom needs access to a line of credit, you never know when you’ll need access to that cash.

Bottom line, a line of credit comes in handy for meeting short-term cash flow needs when you’re running a business. But when it comes to acquisitions that come with a long-term payment plan, a bank loan is your better bet.

When you’re starting a new business, the specialists at Minnwest Bank are there to guide your financing options. We offer customized options and flexible terms to best meet your business needs. To get started, talk to one of our commercial bankers in your community.