Line of Credit vs. Term Loan: A Simple Framework for Choosing the Right One

One of the most common questions small business owners face is whether to apply for a line of credit or a term loan. Both provide access to capital, but they work very differently and suit different situations.

Choosing the wrong product can cost you thousands in unnecessary interest, restrict your flexibility when you need it most, or leave you without funds when opportunities arise. This guide provides a clear framework for making the right choice.

The Fundamental Difference

At its core, the distinction is simple:

• Term loan: You borrow a specific amount upfront and repay it in fixed installments over a set period. Think of it like a mortgage for your business.
• Line of credit: You have access to a pool of funds you can draw from as needed, repay, and draw from again. Think of it like a credit card with better rates.

This fundamental difference drives all the other distinctions in cost, flexibility, qualification, and best use cases.

Side-by-Side Comparison

Here is how the two products compare across key factors:

When to Choose a Line of Credit

A line of credit is the better choice when your funding needs are:

• Ongoing and variable: You regularly need capital but the amounts fluctuate month to month.
• Unpredictable: You cannot forecast exactly when or how much you will need.
• Short-term: You expect to repay within weeks or months rather than years.
• Recurring: You will need access to funds repeatedly, not just once.
• Managing cash flow gaps between invoicing customers and receiving payment
• Purchasing inventory for seasonal demand without knowing exact quantities
• Covering payroll during slow periods
• Having emergency funds available without paying interest until needed
• Taking advantage of early-payment discounts from suppliers
• Handling unexpected expenses (equipment repairs, sudden opportunities)

When to Choose a Term Loan

A term loan is the better choice when your funding needs are:

• One-time: You need a specific amount for a specific purpose.
• Large: The amount exceeds what a typical line of credit would provide.
• Long-term: You need years, not months, to generate the return to repay.
• Predictable: You can calculate the ROI and plan repayment with confidence.
• Purchasing major equipment that will last 5-10 years
• Buying real estate or making leasehold improvements
• Acquiring another business
• Funding a major expansion with clear projected returns
• Refinancing existing debt at a lower rate
• Any investment where the asset life exceeds 2-3 years

The Decision Tree

Use this framework to guide your decision:

• Question 1: Do you know exactly how much you need? If YES, continue. If NO, lean toward a line of credit.
• Question 2: Is this a one-time need or will you need funds again? If ONE-TIME, continue. If RECURRING, choose a line of credit.
• Question 3: Will you repay in less than 12 months? If YES, lean toward a line of credit. If NO, continue.
• Question 4: Is the amount over $100,000? If YES, a term loan may offer better rates. If NO, either could work.
• Question 5: Are you purchasing a specific asset with a long useful life? If YES, choose a term loan. If NO, consider both options.

Cost Comparison: A Real Example

Let's compare the true cost of each option for a common scenario: needing $50,000 for inventory that you expect to sell over 6 months.

*Term loan balance declines slowly over 3 years vs. LOC paid off in 6 months. Despite the higher rate, the line of credit costs significantly less because you only borrow what you need, repay as you generate revenue, and stop paying interest once repaid. The term loan locks you into 3 years of payments even though the inventory is sold after 6 months.

Cost Comparison: When a Term Loan Wins

Now consider a different scenario: purchasing a $150,000 piece of equipment with a 10-year useful life.

For a long-term asset, the lower fixed rate of a term loan and structured principal paydown results in dramatically lower total cost. A line of credit for this purpose would be financially damaging.

Qualification Differences

The qualification process differs between the two products:

The Best Strategy: Have Both

Many successful businesses maintain both products, using each for its intended purpose:

• Line of credit: Acts as a safety net and working capital facility. Costs nothing when unused. Provides flexibility for short-term needs and opportunities.
• Term loan(s): Funds specific long-term investments. Provides lower rates for major purchases. Fixed payments simplify budgeting for known expenses.

For example, a manufacturing company might have a $200,000 line of credit for managing cash flow fluctuations and inventory purchases, plus a $500,000 term loan used to finance a new production line. Each product serves its intended purpose at the lowest cost.

Common Mistakes to Avoid

Business owners frequently make these errors when choosing between products:

• Using a term loan for working capital: Locks you into years of payments for short-term needs.
• Maxing out a line of credit permanently: If you're always at your limit, you need a term loan instead. Lines should fluctuate.
• Choosing based on rate alone: A 10% term loan is not cheaper than a 15% line of credit if you only need funds for 3 months.
• Waiting until desperate to apply: Both products are easier to obtain when your business is healthy. Apply proactively.
• Ignoring total cost: Factor in all fees, not just interest rates, when comparing options.

Quick Reference: Your Choice at a Glance

Use this summary to quickly identify the right product: