Key takeaways
- Use a line of credit for short-term, repeating needs: seasonal inventory, payroll gaps, waiting on customer payments.
- Use a term loan for long-term investments with a payback period of years: equipment, expansion, buying a business, refinancing.
- The most expensive mistake is a mismatch: funding long-term investments with short-term money, or carrying a permanent balance on a line of credit.
- Lenders judge both on cash flow. Check your debt service coverage before you apply with the business loan / DSCR calculator.
Small business owners usually do not lack financing options. They lack a clear way to match the right type of debt to the right need. Pick well and debt becomes a tool that smooths cash flow and funds growth. Pick badly and a manageable cash crunch turns into a debt spiral. This guide compares the two most common forms of bank financing and shows how to choose.
What is a business line of credit?
A line of credit is a revolving facility. The lender approves a maximum amount, and you draw what you need, when you need it. You pay interest only on the amount you have drawn, and as you repay, the credit becomes available again.
Typical features:
- Variable interest rate, often tied to the prime rate
- Annual renewal and review, sometimes with an annual fee
- Interest-only payments on the outstanding balance, or small principal payments
- Often secured by receivables and inventory (an asset-based line), plus a personal guarantee
- Many banks require a “clean-up” period, for example 30 days a year with a zero balance, to prove the line is used for short-term needs
What is a term loan?
A term loan provides a lump sum that you repay on a fixed schedule over a set term, typically one to ten years (longer for real estate). Each payment includes principal and interest, so the balance falls steadily to zero.
Typical features:
- Fixed or variable rate
- Fixed monthly payment and maturity date
- Often secured by the asset being purchased, business assets and a personal guarantee
- Can be a conventional bank loan or SBA-backed (7(a) or 504), which allows longer terms. See SBA loan DSCR requirements.
Side-by-side comparison
| Line of credit | Term loan | |
|---|---|---|
| How you receive funds | Draw as needed up to a limit | One lump sum |
| Repayment | Revolving; pay down and reuse | Fixed schedule to zero |
| Interest | Only on the drawn balance; usually variable | On the full outstanding balance; fixed or variable |
| Typical uses | Inventory, payroll timing, receivables gaps, small emergencies | Equipment, vehicles, expansion, acquisitions, refinancing |
| Term | Usually renewed annually | 1–10 years (up to 25 with real estate) |
| Cash flow impact | Low payments while balance is small; can rise quickly | Predictable monthly payment |
| Main risk | Line becomes a permanent loan; may not be renewed | Commits you to payments for years |
Real cost examples
A line of credit used the right way
A landscaping company has a $100,000 line at 11%. Each spring it draws $40,000 for materials and labor before customers pay, and repays it from summer revenue over about six months.
Interest cost: roughly $40,000 × 11% × 6/12 = $2,200 for the year. The line costs little because it is used briefly and repaid.
A term loan used the right way
The same company buys 100, 000ofequipmentwithafive − yeartermloanat92,076 a month**, and total interest over five years is about $24,550. The equipment generates revenue for many years, so a five-year repayment matches its useful life.
The mismatch
Now imagine the company buys the equipment with its line of credit. The line is maxed out, the bank’s annual review shows a balance that never goes to zero, and when a slow season arrives there is no room left to cover payroll. At renewal, the bank may reduce the line or ask for repayment. That is how a profitable business ends up in a cash crisis.
How to choose: five questions
- How long will this need last? Under 12 months and repeating: line of credit. Multi-year benefit: term loan.
- Is the amount predictable? Variable, recurring needs fit a line. A known one-time cost fits a term loan.
- Can the business handle a fixed payment? Run the numbers. Lenders generally want a debt service coverage ratio of at least 1.25 on all business debt. Our article on what a good DSCR looks like explains why.
- What collateral is available? Receivables and inventory support a line; equipment and real estate support a term loan.
- What happens if rates rise? Variable-rate lines become more expensive quickly. A fixed-rate term loan locks your cost.
Many healthy businesses use both: a term loan for long-lived assets and a modest line of credit for working capital, with a policy to clear the line at least once a year.
Watch out for expensive alternatives
When banks say no, owners often turn to faster products. Some can make sense for a short, specific need, but they are costly and can damage cash flow:
- Merchant cash advances (MCAs): an advance repaid through a share of daily card sales or daily bank debits. The cost is expressed as a “factor rate,” which can translate into very high effective annual rates. Stacking several MCAs is a common route into serious business debt trouble.
- Short-term online loans with daily or weekly payments.
- Business credit cards carried at a balance for long periods.
If these products are already squeezing your cash flow, read our guides to managing business debt and business debt restructuring. Many owners also signed personal guarantees without realizing how far their liability extends; DebtRemediation.org explains this clearly in business debt, personal guarantees and the limits of protection.
How lenders evaluate your application
For both products, expect lenders to ask for:
- Two to three years of business tax returns and financial statements
- Interim year-to-date financial statements
- A debt schedule listing every business loan, lease and line
- Personal financial statement and tax returns for owners of 20% or more
- An accounts receivable aging report (for lines of credit)
- A use-of-funds explanation or business plan for larger term loans
A clear, lender-ready package shortens approval time and can improve terms. Foxboro Consulting Group helps companies prepare financing packages through its capital financing and offering memorandum services and business plan development. For larger decisions, understanding your true cost of capital helps you compare debt with other funding sources.
Frequently asked questions
It can be, because you pay interest only on what you draw. But line rates are often variable and can be higher than term loan rates. The cheapest option is the one that matches how long you need the money.
You can, but it is usually a mismatch. Equipment pays for itself over years, while lines are reviewed annually. A term loan or equipment financing typically fits better.
Requirements vary by lender. Banks generally want good personal credit for owners, at least two years in business and steady revenue. Newer businesses may need an SBA-backed line or a secured line.
A requirement that the balance be paid to zero for a set number of consecutive days each year, showing that the line funds short-term needs rather than permanent capital.
Often yes, if you qualify, because a term loan typically costs far less and has predictable payments. Compare the payoff amount, any prepayment terms and the new monthly payment before deciding.
Next step
Before you apply, run your numbers through the business loan / DSCR calculator. If you need help building a lender-ready financing package, talk to Foxboro Consulting Group.
This article is for general education and is not lending, legal or tax advice. Rates and terms vary by lender and market conditions; examples are illustrative.
