Business owners know how vital it is to be able to access cash from time to time and keep operations humming along smoothly. Whether you’re investing in new equipment, need to make payroll, or want to stock your shelves with the latest hot seller, there’s no shortage of situations that require significant liquidity.
To get the funds they need, most business owners choose one of two things: a commercial loan or a commercial line of credit. While there are similarities between the two, it’s important to understand the differences, and how each is best utilized.
What is a commercial loan?
A commercial loan is basically the same as a personal loan. The business owner finds a willing lender and agrees to borrow a lump sum of money, paid upfront and repaid in installments over a predetermined period, usually between one and 20 years.
Loan payments are usually monthly but can also be every two weeks. The lender charges interest on the original loan amount, also known as the principal. Most commercial loans have fixed interest rates, but some have variable rates, meaning both the interest rate and payments may fluctuate over time. One benefit of a fixed interest rate is that it ensures consistency in your payment, allowing you to make budgeting decisions based on that amount for as long as your rate is guaranteed.
In most cases, commercial loans require the borrower to pay what are known as closing costs, including a commitment fee which is usually a small percentage of the total amount borrowed. It’s important to understand these costs and budget for them when you apply for any loan.
Finally, most commercial loans also require some sort of collateral as security for the principal. You’ll pay a lower rate of interest on a secured loan than one that’s unsecured.
What is a commercial line of credit?
A line of credit provides revolving access to a fixed amount of cash and is a great way for businesses to access the funds they need to cover seasonal spending, emergency expenses, or other unforeseen costs. Think of a line of credit as a financial security blanket for your business.
Once approved for a line of credit, you can borrow as much or as little of the amount as you wish. For instance, if you’re approved for up to $50,000 and borrow $20,000, you still have access to $30,000.
Once borrowed, the money must be paid back, along with interest. Lines of Credit are payable on demand so there’s typically no set timetable for repayment, but borrowers are required to make a minimum payment each month and the accounts should see regular fluctuation. Paying the minimum can be handy if funds are tight, but this approach will end up costing you more in interest over the long run.
After you’ve paid back any borrowed amount, you can use some or all of it as credit again. That way, your business can continue to get access to cash without having to apply for a new loan and pay more closing costs.
As much as possible, it’s best to use a commercial line of credit to pay for things that will ultimately generate income for your business. That way, you’ll be better able to pay back what you’ve borrowed.
Interest rates on lines of credit tend to be variable rather than fixed. However, if you fail to make the minimum payment or borrow beyond your credit limit, you could be subject to costly penalties or significant interest rate increases on your remaining balance.
When and how to use each one
A basic rule of thumb is that a loan is something you get when you need it, and a line of credit is something you should get before you need it.
Another way to think of the difference is that loans are better for long-term debts, while a line of credit is best used to pay for short-term needs.
Here’s an example of when to get a commercial loan. Say your business wants to finance the purchase of a new and expensive piece of equipment that costs $100,000. You’d have to exhaust your line of credit to cover such a purchase, leaving you without access to emergency funds. The new equipment has a projected lifespan of 15 years, so the best approach is to obtain a loan with a repayment term that matches that time frame. If you’re able to pay the loan back more quickly, all the better – you’ll end up saving on interest.
Here’s an example of when to use a line of credit. Imagine you run a pool cleaning company. Spring and summer are your busiest times, but funds are scarce in the winter when business is slow. That leaves you with a cash crunch in early spring when it’s time to market your services for a new season. Tap into your line of credit to cover the cost of new flyers and advertising, then pay the balance back over the course of the summer when your income is higher.
Learn more about Moya’s business borrowing options.