The Difference Between A Line Of Credit And A Loan

08/12/2016 06:44 pm ET Updated Aug 13, 2017

Small businesses often need outside financing if they're going to get the funds they need to fund their operations. Right now money is pouring into startups, with 1800 venture capital deals happening in 2015 alone. A lot of entrepreneurs don't understand the difference between loans and a line of credit. There are a number of important differences you have to take into account when making decisions of this magnitude.

This guide is going to discuss what a business line of credit is and what a loan is so you can make an informed decision about your financial future.

What is a Typical Loan?

A typical loan will usually boil down to things like mortgages, auto loans, and student loans. The amount you pay back is known from the start. The amounts you pay will be kept relatively similar, and you'll pay back in equal installments. A typical loan is what most businesses try to secure.

You can find loans of all types and all sizes, including those tied to national interest rates, such as with mortgages.

What is a Line of Credit?

A line of credit is a financial tool used far less often than loans. You mainly see lines of credit used for businesses and for home equity. There's a borrowing limit extended to the person asking for money. More money can be borrowed only after that amount has been paid.

The majority of lines of credit have no end date. The only principle is you have to pay back one line of credit before you can get another line of credit.

The General Differences Between the Two

There are actually lots of general differences between the two. A standard loan will always be used for a big ticket item, such as a car or a house. Many of these standard loans are also secured against existing assets. For example, a mortgage is always secured against the house you're trying to buy.

Lines of credit usually come with higher interest rates, but the minimum payment you have to make is lower. You'll also find that a line of credit will create a bigger impact on a credit report.

If there are any closing costs, you'll find them to be lower with lines of credit. But these are only general differences and the chances are they won't influence your decision significantly.

The Beginning of the Process

You'll notice a big difference between loans and lines of credit immediately. To start with, you'll find that a loan is always for a pre-approved purchase. You'll need the lender's approval before they will give you any cash to work with. A loan will also allow you to receive all the money in one and you'll be paying interest on that money from day one.

Lines of credit work slightly differently. For a start, you don't have to get the lender's approval before buying anything. In fact, they won't know what you will use the line of credit for before until you start using it. You're being approved for a line of credit in general, as opposed to any specific purchase.

The line of credit also won't give you any money directly. You'll only receive money when you actually need it because you'll be buying using the line of credit. And the interest rates will only kick in on the amount you spend.

Many would argue that the line of credit is a far more flexible way of borrowing money. You only pay back when you need to and on what you actually spend.

What's the Downside of a Line of Credit?

It would make sense that a line of credit does come with its downsides, though. The main problem with a line of credit is that there's no certainty when it comes to the lender. They don't know when they're going to extract any money from you. To counter this, they increase the interest rates, and a lot of lenders will demand higher standards from people who want them.

It's becoming extremely difficult to get an unsecured line of credit, for example. Secured lines of credit are becoming more common. You don't secure it on a relevant asset, but you may be asked to put up some of your personal assets.

What's the Best Option for Your Company?

The best option for your company is easily a line of credit. They're like credit cards, except without a minimum monthly payment. There are higher interest rates involved, but on the other hand you're also only paying back what you actually spend. In many ways this offsets the increased payments you're making.

Will you be taking out a line of credit?