Financial Education: Understanding the Difference Between a Line of Credit and a Loan

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Financial Education: Understanding the Difference Between a Line of Credit and a Loan

Seeing a small business trying to find a way to get financed is not that uncommon at all. Many business owners just like you have likely found themselves in a similar situation before, and surprisingly, that has a positive side to it – they’ve shared what they’ve learned, which means you can learn from their findings and mistakes.

Today, we’re going to be passing on the knowledge we have on the subject as well, and hopefully answer as many questions you might have regarding the difference between a line of credit and a loan (as well as anything else that’s related to the subject).

On to the first point!

Line of credit – the basics

A line of credit can be viewed as a personal credit card. As funny as it may sound, in terms of functionality, things tend to be quite alike. Most businesses apply for this type of loan when they’re going to be facing unforeseen costs in the future.

In technical terms, a line of credit can either be secured or unsecured (“revolving” is another term you may have heard that describes this). For example, let’s assume you have a $10,000 line of credit. At any time, you can decide to take $6,000 out, without losing access to the remaining $4,000.

Now here’s the thing; when you return what you’ve borrowed, you can access the full $10,000 again without having to reapply.

Therefore, a line of credit functions like an ongoing loan contract and it’s a great way to minimize the time spent on negotiating individual loans. Instead, you can take that time and invest it towards growing your business (or anything else you believe is going to benefit you).

In a practical scenario, imagine you need to get some work done like changing your wall decorations, installing a new mirror, or something of the like. You know that you’re going to pay for the contractors’ work, but since the workload can sometimes vary (and so can their effective working hours), you don’t know how much it’s going to cost. In such cases (given that you can’t afford to pay them out of pocket), going for a line of credit makes a whole lot of sense.

How about a traditional loan?

A traditional loan is a legitimate option as well. However, there are some differences you need to be aware of.

For starters, a traditional loan typically involves borrowing a large sum of money and it’s a one-time deal. When the deal is inked, the clock starts ticking, and you’re required to pay it back within the timeframe you’ve agreed upon.

Of course, you receive the money in an instant as well. Depending on the deal, you either have a year to repay it, or a couple of decades (this mostly depends on the total amount of money you’ve borrowed).

In terms of interest rates you can expect, these typically range anywhere between 5% and 12%. But remember, this can vary, so the rate you can expect to pay depends on the individual lender you choose to work with.

Now, let’s briefly take a look at a concrete situation that calls for a traditional loan. Let’s say you’re launching your first brick and mortar store or that you’re expanding your business to a new region. You’re going to have to pay a bit of money to reach these goals; however, these goals are pretty clear in terms of costs. You’re not really dealing with any variables. Therefore, a traditional loan is a smart path to take.

What are the main differences between a line of credit and a loan?

Now that the basic definitions are out of the way, let’s compare these two popular options and look at the main differences between them. As already stated, a traditional loan is suitable for long-term situations where the costs are pretty much known in advance, while a line of credit is suitable for short-term situations where there are plenty of unknown variables.

Difference #1: Interest rates

When it comes to interest rates, there are certainly some differences. When you take a traditional loan, the interest rates are fixed, at least you can expect them to be. Basically, during the entire time period of paying it back, you’re going be making fixed interest payments.

Going for a line of credit, on the other hand, is a different story. As you might have guessed, the interest rates are going to vary with these. However, you will only be required to pay interest based on the total amount of money you decided to borrow. Moreover, you can expect to pay lower interest rates compared to traditional loans.

Difference #2: Payment terms

In terms of when you’re expected to pay the money back, both of these types of loans require you to make monthly payments. The difference is in the details; namely, in the amount of money you’re using in case you opt for a line of credit. Revisiting the example laid out above, let’s say you have just received a green light for it and you have all the $10,000 to work with. If you don’t borrow anything that month, you won’t owe a dime.

Difference #3: Fees

Fees are another thing that differentiates a line of credit from a loan. As far as traditional loans are concerned, you can’t avoid having to pay appraisal and processing fees. Sure enough, processing fees are unavoidable even when opting for a line of credit and you’ll have to deal with them every single time you decide to make a draw.

The closing costs, however, cannot even compare between them, since they’re going to be much higher with a traditional loan than a line of credit.

A side-by-side comparison of the processes

There are considerable differences between the processes as well. For starters, a loan is always pre-approved, meaning that you’re going to need the lender’s approval prior to receiving the money. Also, you’ll be paying interest on the loan from the very get go (in other words, from day one).

A line of credit, surprisingly, does not require you to get the lender’s approval. In fact, they won’t even notice you until the point of you making the first purchase. Since you only receive the money when buying something, this is quite understandable. As such, there are also no interest fees until that very point.

The consensus is that a line of credit is much more flexible than a loan. Essentially, it doesn’t cost you a thing, unless you actually need to use the funds to pay for something, and it’s an option that’s always available to you in case you need it.

However, is a line of credit always the best way to go by default?

The downsides of a line of credit

As you’ve probably guessed, a line of credit does come with its own set of downsides. No matter how you put it, there’s way less certainty when it comes to the lender. Financial institutions aren’t charities; as such, they need to make their money somehow. Since they don’t know when they’re going to be making money from the line of credit deal they offer you, some providers may actually try to introduce higher interest rates. This is why it’s especially important to do your homework and choose the best lender.

In any case, getting an unsecured line of credit is becoming much harder these days. A secured line of credit is much more common in comparison. Even though they won’t ask you to secure it on a relevant asset, you can still be asked to put up a personal asset that you own.

Which option is the best for a typical business?

Since you’re the one who’s most familiar with your business needs, this is a question that only you can answer. As we’ve already mentioned, if you know your costs are going to be one-time only and if you’re familiar with the exact numbers upfront, then going for a traditional business loan is a great decision.

On the other hand, if you know that you’re going to need to borrow some money, but there are tons of unknown variables you can’t possibly know in advance, then by all means, go for a line of credit. If nothing else, this will allow you to have the ability to pay for unforeseen costs, even if you aren’t able to cover them straight out of pocket.

Besides, if you end up not needing to borrow the money, no harm no foul, right? Since you won’t be required to pay anything as a result of this, there won’t be any negative consequences, so there’s no need to worry about a thing.

Conclusion

In conclusion, that’s pretty much it! Now, you not only know the difference between these two popular types of loans, you’re also going to be able to make an informed decision about which one would best suit your needs. The next time you’re going to find yourself in a similar situation, you’ll know exactly what to do.



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