In the era of financial planning for the business and personal needs, it is crucial to get the insight of the available financing methods. There are two types of credit products – the term loan and the line of credit. 

Although both offer funds, how they work is pretty different, and for what circumstances, different passes the need. In this blog, the authors will explain what term loans and lines of credit are, the pros and cons of each, and which option may be better suited to each business.

What is a Term Loan?

A term loan can be defined as a type of credit provided by a financial institution to a borrower for a specific amount of money in order to finance an investment that is expected to generate substantial returns within a particular year.

Term loan is a loan that a borrower receives from a financial institution in one go whether secured or unsecured and the same is repaid in a fixed amount with an interest rate, either fixed or floating as agreed with the lender. 

These loans are usually taken with a definite plan in mind such as acquiring equipment, building or any other fixed assets.

Characteristics of Term Loans

• Fixed Amount: Borrowers get their loan amount in full at the initial instance of the loan trapping time.
• Repayment Schedule: The payment is made in equal or unequal instalments over the period which may last from 1 to 10 years.
• Interest Rates: May be of a fixed nature or variable; the former may affect the overall repayment amount.
• Purpose-Specific: Typically associated with activities such as capital expenditures or other works that more than a certain amount of money costs.

Advantages of Term Loans

• Predictability: Housing that involves paying a fixed amount of money every month makes for easy planning.
• Large Sums: Applicable for big tickets that need a significant amount of money to fund the investment.
• Interest Rates: Sometimes lower than on lines of credit, but this is more commonly seen in secured forms of loan.
• Builds Credit: Effort in paying back loans on time boosts credit scores.

Disadvantages of Term Loans

• Rigid Structure: This is arising from the fact that mortgages have a repayment plan that is not very flexible as compared to lines of credit.
• Collateral Requirement: Some of the term loans have conditions whereby borrowers have to provide security to access funds, thus exposing their property to the lender.
• Qualification Criteria: May involve other conditions such as having a good credit profile and producing financial statements.

What is a Line of Credit?

A line of credit is a type of credit where the credit limit is not fixed, but is varied according to the financial requirement of the borrower. It can be compared to a credit card in terms of its features, as it has a revolving credit, which can be spent, paid off and spent again.

In its simplest form, a line of credit is a credit card, although the terminology utilized may be different and some lines of credit are more complicated than credit cards.

Characteristics of Line of Credit

• Flexibility: The credit extended to the borrowers can be availed by the borrowers at their convenience up to the extent of the credit limit agreed with the provider.
• Revolving Balance: Moneys can be borrowed, repaid and borrowed again depending on the prospect of the investment.
• Variable Interest Rates: Interest is always charged progressively on the cash that has been borrowed and not on the total credit limit.
• General Use: Supplemental working capital financing can be employed for working capital, for emergencies, and for short-term requirements.

Advantages of Line of Credit

• Flexibility: Moreover, that provides a possibility for borrowers to use the funds whenever they need it – it is more convenient for cash flow.
• Interest Savings: They only pay a certain amount of interest on the borrowed amount and not on the total credit facility limit granted.
• No Collateral Needed: It is usually a form of credit without collateral, meaning that the risk of the borrower would be more minimized.
• Quick Access: Fast accesses to funds are possible for immediate requirements.

Disadvantages of Line of Credit 

• Unaffordable and Unsustainable: It is expensive to service and unmanageable in the long run.
• Variable Interest Rates: This is because rates vary from one period to another and this makes predicting the costs of interests quite challenging.
• Temptation to Overuse: This paper aims to discuss the implication of strengthening of the financial structure and easy access to funds that consequently leads to over borrowing and financial pressures.
• Renewal and Fees: Lines of credit may come with annual renewal fees and require periodic credit reviews.
• Higher Interest Rates: Usually above the term loans but occasionally it is lower if the line of credit is only unsecured .

Comparing Term Loan With Line Of Credit

Some of the factors that one needs to consider are the nature of the expenses and income, the ability to repay the term loan or the total amount from the line of credit, and the financial standing of the business.

Consider Your Purpose

• One-Time Expenses: If you require a lump sum of money for a large, essential business expense like buying equipment or properties, term loan would typically be useful. 
• As this type of financing offers a lump sum, this type of financing can be repaid over a set period with fixed payment terms.
• Short-Term Needs: A line of credit is perfect for achieving those goals because, in contrast with a term loan that provides a lump sum, you can access cash as you need it, pay it back to later draw more if needed, and pay interest only on the amount you’ve borrowed.

Evaluate Your Financial Situation

• Creditworthiness: Term loans and lines of credit are both accessible for individuals with a good credit rating and indeed strong credit history is likely to increase the chances of being approved for both types of loans although the requirements for obtaining term loans tend to be slightly more rigorous. There is a chance that lines of credit can be easier to obtain if your credit is just average .
• Repayment Ability: Think of taking periodic fixed installments as compared to the choices available to pay the money back as and when the money is exhausted or not. Term loans cases require close monitoring of the budget and lines of credit contain flexible options for repayments.

Assess Interest Rates and Fees

• Interest Rates: Since it is usually optional where one can draw his/her financial slot, one needs to compare the interest rates given to either option. Term loans are usually cheaper in terms of interest, but for a business that only requires credit items occasionally it may be cheaper to use the line of credit.
• Fees and Charges: Also consider other costs related to the type of the financing, – origination costs for the term loans or recurring costs for the lines of credit.

Risk Tolerance

• Collateral Requirements: The funds are secured by taking the assets of the borrower at risk and term loans may entail taking the collateral. If this is not ok with you, an unsecured line of credit might be desirable to you.
• Interest Rate Fluctuations: Fixed payment of all the money in a term loan is preferable over the other since they offer stability in their payment structure. Nevertheless, if a person is comfortable working with the variable rates and likes the ability to borrow more than they-probably a line of credit is beneficial.

Term loans are a specific amount of money borrowed for a specified purpose with an agreed-upon rate of interest which have to be paid back over an agreed period with or without a collateral while lines of credit on the other hand is a more flexible type of loan where and when need arises one can borrow the funds without further permission although the interest rate may be slightly higher. 

Direct loans offer a large sum of money for which the payments are constant, thus suitable for purposes of making large, set expenditures. Other types of credit, such as a line of credit, are good and more flexible as they are suitable for dealing with short-term or recurring costs.

All in all, to make an informed decision between extending for a term loan or a line of credit, the borrower should weigh factors like his or her financial status, intended use of the funds and his ability to meet payments on the borrowed money. 

It is thus possible to determine which of the financing sources you wish to go for that best suits your objectives and the requirements of your business.

Blackstone Funding can provide various financing options tailored to your business needs, so evaluate which option best suits your objectives and requirements.