Should You Get a Line of Credit or Business Loan?
Thinking about getting a line of credit for your business, or taking out a business loan? It’s a question we hear quite a bit from our clients. Here are some considerations to help you make the smartest choice for your business.
My dad taught me MANY things growing up, and there were a lot of sayings or lessons that I still know and use till this day. I actually shocked a high level fund executive in my first year as a staff accountant with my knowledge of insurance, umbrella policy and defense at only 23 years old.
This is because my dad always took the time to explain things to me AND because I was a sponge listening, absorbing, asking questions and committing it to my long term memory! It wasn’t always about money or economics, but that constituted a vast majority of it since I come from a family of entrepreneurs.
I want to share one of these lessons with you, because it’s a question many of our clients wonder: Should they get a line of credit, or take out a business loan?
Should You Get a Line of Credit or Take Out a Loan?: A Lesson
My dad always told me that no one will lend you money when you need it, but they’ll lend it to you when you don’t.
Seems weird, right? What’s the point of a loan if you can’t get it when you actually NEED it? You can probably imagine my 10 year old brain trying to process this.
Recently, one our clients and her bookkeeper asked if we agreed that she should get a loan for the business. They were thinking about $50,000 or so from the SBA. Cash has been a little tighter than usual(side note: everyone is feeling this right now) and they’re thinking ahead and just trying to plan for different scenarios.
Consider a Line of Credit Instead
I absolutely agreed that it was a smart decision, with one suggestion – getting a Line of Credit instead of a traditional loan. At a high level, a line of credit and fixed loan differ in how the funds are accessed, how interest is charged, and how the loan is repaid. They are both necessary but shine in different ways! Here’s how:
Withdraw money as you need
With a line of credit, you can withdraw money as you need up to the amount of the credit limit whereas a fixed loan gives you the total lump sum of money upfront. Lines of credit typically have a variable interest rate which is usually higher than the fixed interest rate on a traditional loan.
Only pay interest on the amount you currently have taken out
With a line of credit, you only pay interest on the amount you currently have taken out to use. You pay the interest back each month but you don’t have to pay any of the principal. You can choose to pay more than just the interest but you don’t have to. With the traditional fixed loan, you make consistent monthly payments that include both the interest and the principal over a specified amount of time.
Unless you’re financing something specific – a building purchase, a new piece of expensive equipment, and a new division of your business – a line of credit is going to be the cheaper option (even though the interest rate is higher). That’s because you’re only paying interest IF you need to use the money. It’s a rainy day fund keeping you prepared for whatever lies ahead in your business!
Get a Line of Credit When Business is Good
And this brings me back to the whole “no one will lend you money when you need it” concept.
If you wait until you NEED money, the bank is unlikely to give it to you because it’s RISKY for them. Banks/lenders want a sure fire thing of getting their money back. When your business looks good on paper and in real life, they are SURE that they’ll get their money back.
I’m not saying that this is definitively true. I’ve seen businesses that look successful on paper fail and those that look awful on paper thrive. But at the end of the day, the banks have a piece of paper with financial information on it… and that’s what they’re going to use to make their decision. And bankers/lenders/underwriters are very risk averse people.
When your business looks good, that’s the time to get a line of credit setup! It’s always better to be prepared instead of scrambling!
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Disclaimer: This article is not meant to be tax advice. This is not an all-inclusive list of business advice. Different rules may apply to each individual taxpayer’s specific situation. Please consult with your accountant. May contain affiliate links.
