The Difference Between a Line of Credit and a Term Loan

Why this matters

Business debt comes in two basic shapes, and shops routinely reach for the wrong one. Fund a new truck on a line of credit and you tie up the tool you need for emergencies in an asset that will not free it back up for years. Take a rigid term loan to cover a swing that lasts a few weeks and you are stuck making fixed payments long after the need passed. The tool is not good or bad on its own; it is right or wrong for the job. Learn the two shapes and matching them becomes obvious.

What a line of credit is

A line of credit (often just "a line" or LOC) is revolving, reusable credit up to a set ceiling. The bank approves a limit; you draw what you need, pay interest only on the drawn balance, pay it back down, and the room becomes available again. It works like a credit card built for the business, usually at a lower rate, secured against your receivables or general assets.

The defining trait: it goes up and down. You are meant to use it, repay it, and use it again, over and over.

What a term loan is

A term loan is a lump sum handed to you once, repaid in fixed installments over a set period (the term), at a rate that is often fixed. You get all the money up front, and from there it only shrinks. When it is paid off, it is gone; there is nothing to draw again without applying for a new loan.

The defining trait: one-way. Money in once, then a predictable schedule of payments until zero.

Side by side

Match the tool to the need

The single decision that matters is whether the need is temporary and fluctuating or one-time and long-lived.

• Bridging a gap (a receivable you have earned but not collected, inventory you will sell soon, a seasonal swing) is a line-of-credit job. The need appears, you draw, the money comes back, you repay. The debt should self-liquidate, meaning the thing you funded generates the cash that pays it off.
• Buying something that lasts (a truck, a major tool, a buildout, a business you are acquiring) is a term-loan job. A long-lived asset should be paid for over its working life, not out of a revolving line meant to reset to zero.

Say it as a rule: short-term and fluctuating goes on the line; one-time and long-lived goes on a term loan.

The classic mistakes

• Funding a long-term asset on the line. The line never gets back to zero because the truck does not throw off a lump of cash to clear it. Now your emergency tool is permanently used up, and you are paying a variable rate on what should have been fixed long-term debt.
• Living on the line. If the balance only ever grows and never rests at zero, the line has quietly become a term loan you never underwrote, and it is usually a sign the business is losing money, not just timing it. See related: Using a Line of Credit the Way It's Meant to Be Used.
• Taking a term loan for a short need. You borrow a lump for a few weeks' swing, then carry fixed payments for years. A line would have cost interest only while drawn.

When you might want both

Mature shops often run both at once, and they do different jobs. The term loan carries the durable assets. The line smooths the week-to-week timing between finishing work and getting paid. Kept in their lanes, they cover the two problems every growing service business has: buying what lasts, and bridging what does not line up.

References

• U.S. Small Business Administration (SBA), types of business financing
• Trade-standard practice on matching debt structure to use of funds
• See related: Using a Line of Credit the Way It's Meant to Be Used; When Financing Equipment Makes Sense and When It Doesn't; Factoring vs Line of Credit