Optimizing Your Business Financing: Fixed-Term Loan vs. Line of Credit
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As the owner of a business, you will likely need to acquire financing at some point to assist your company with scaling up in size. You could also require funding to help with working capital needs, debt consolidation, or purchasing significant business assets.
Whatever the driver may be, it is important to determine the most appropriate options for obtaining debt financing. When looking at debt financing, it is helpful to understand what is a fixed-term loan vs. a line of credit.
What Is a Fixed-Term Loan?
A fixed-term loan is given as a lump sum with a set interest rate. A specific amount of time is allowed to repay the loan. Monthly payments are generally set and do not vary unless attached to a variable interest rate.
FURTHER READING: A Business Owner's Guide to Business Loans
Is a Small Business Loan a Variable or Fixed Rate?
A fixed interest rate is a set rate that is attached to a loan at its inception. It does not change throughout the life of the loan. The benefits of a fixed-rate loan include knowing exactly what the monthly payment is going to be throughout the life of a loan. However, the interest rate is typically higher than a variable interest rate loan.
A variable interest rate is usually tied to a specific benchmark, such as LIBOR or the Prime Rate. The LIBOR is the basic interest rate used by banks on the London interbank market. The Prime Rate or Prime Lending Rate is the lowest interest rate at which banks can commercially lend. In the US, these are set individually by each bank but are usually based, in part, on the current Federal Funds Target Rate. Often, a small additional margin is added to the benchmark to account for risk and overhead expenses from the lender.
Monthly payments made on variable interest rates generally change from month to month. With a variable rate loan, there is the risk that the interest will increase significantly, especially if the loan is not paid off quickly.
The type of loan acquired will typically dictate the interest rate type that is used. So is a small business loan a variable or fixed rate? It depends.
What Is a Fixed-Term Loan Generally Used For?
A fixed-term loan is usually used for large purchases of business assets, refinancing debt, or opening a new company location.
How Does a Fixed-Term Loan Work?
A fixed-term loan results in a business receiving a specific amount of money at the beginning of the loan. The monies can be used to purchase large-ticket items, open a new location, or for other purposes. They generally have repayment terms of one to five years and allow the company to borrow between $25,000 and $500,000.
Once you receive the funds, you will be responsible for regular payments throughout the life of the loan. These payments may be made daily, weekly, or monthly. Usually, a fixed-term loan will have a repayment period of between one and five years and an interest rate between 7 and 30%.
To obtain a fixed-term loan, a company will work with a commercial bank or other lending institution. There are often stringent requirements to obtain this type of loan:
- Typically, a business must have at least three years of business history
- Over $300,000 of annual revenue
- A good credit score (at least 680)
There may also be a requirement for collateral or the potential of a blanket lien, where the lender will be entitled to the business assets if payments are not made.
What Is a Line of Credit?
A line of credit is similar to a credit card. A commercial bank or other lending institution grants a company the right to access a specific amount of debt. The company can then draw on these funds as needed. There is no requirement to withdraw the maximum, and the company is able to utilize it only as required.
What Is a Line of Credit Used For?
A line of credit is typically used to meet ongoing working capital needs or for emergency funding.
How Does a Line of Credit Work?
A line of credit works by obtaining the right to use a specific set of funds. The business may draw on as much or as little of the available funds as required at any time it chooses.
Typically a company will obtain a line of credit for an amount between $10,000 and $1 million. It is usually revolving, which means that the credit is there permanently, although certain contracts may set the length of the loan for a specific period, such as between six months and five years.
Interest rates are typically variable and may range between 7 and 25%.
It is generally a bit easier to obtain a line of credit than it is to obtain a fixed-rate loan. A lender will usually want to see:
- At least one year of business history
- A reasonable credit score (630+)
- Over $180,000 in annual revenue
If the company meets these requirements, it will most likely be able to obtain a line of credit from a bank or other lender.
Fixed Term Loan vs. a Line of Credit
When you're considering which type of loan to apply for, consider what you will be using the funds for and which loan type your business is more likely to qualify for. You should also consider the affordability of meeting monthly payment requirements.
For example, if you are seeking debt funding that you plan to use for purchasing an expensive machine that can be used to make products, you will most likely want to take out a fixed-term loan.
The fixed-term loan will give you a specific number of payments over a given period of time, most likely with a fixed interest rate. Hopefully, your business will meet the requirements to obtain the loan; if it does not, you may need to consider a line of credit instead.
A business line of credit is a good option for those seeking to have funding available if needed. The company may use it sporadically as events occur that require financing when cash is not readily available.
It’s best to open a line of credit when it is not needed at all; that way, the company avoids any stress that comes from finding immediate financing if such an event occurs in the future.
How to Know If a Fixed Term Loan vs. Line of Credit Is Right for Your Business?
Any business typically requires some type of debt financing as it grows. However, companies may vary in how much they wish to borrow, how much they are able to afford, and their ability to make regular loan repayments.
The requirements that lenders set out may not allow a business to obtain debt financing, especially if the company is very new and doesn’t have a significant business history.
If you are considering taking out a loan for your business, ensure that your company has the cash flow available to cover any regular monthly payments. Also, consider your company’s credit history and what it intends to do with the funds it receives.
It may make sense to obtain both types of loans in some cases. For example, if you plan to purchase a significant business asset, your company could obtain a fixed-term loan. However, you may also want a line of credit as emergency funding, should something occur in the future where money is needed.
How Can You Get a Term Loan or Line Of Credit?
If you would like to obtain a term loan or line of credit, consider working with a commercial bank or alternative lender.
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