It’s finally happening! You’ve decided to take a chance and turn your business idea into a reality. The problem? You still need to figure out exactly how to finance your dream. This is where loans and lines of credit can come in handy. However, it may be hard to tell the difference between them – especially if these terms are relatively new to you. That’s why the FFB Blog is here to help by defining what a loan is, what a line of credit is, and the similarities and differences between the two.

What is a Loan?
A loan is one type of borrowing method that can be used by businesses and individuals at financial institutions. When you borrow a loan from a bank or other financial institution, you’re borrowing a certain amount of money that you’re expected to pay back in full at a future date. With most loans, there are several elements to consider, including principal, loan term, interest rate, and loan payments.

  • Principal is the original amount of money that you are borrowing.
  • The loan term is the time you have to pay back the full amount of the loan.
  • The interest rate describes the cost of borrowing the loan and will affect the total amount that needs to be paid back. The interest charged will create additional funds that need to be paid back at the end of the loan.
  • Loan Payments are spread out over the life of the loan and consist of fixed amounts of money that are paid back toward the loan. They help to ensure that the loan will be paid back in full at the end of the loan term. Some loans may         even have a balloon payment due at the end of the loan term if the amount of the loan payments is not enough to cover the entire amount borrowed.

What is a Line of Credit?

Another borrowing method is the line of credit, which works similarly to a credit card. When you open a line of credit at a bank, you agree on a set borrowing limit. The funds can then be accessed at any time until that limit is reached, or the line of credit is closed.

Like a loan, a line of credit will need to be paid back and it includes interest and a time limit. The amount of time that a line of credit remains open depends on your agreement with your bank. However, it can last for several years. Meanwhile, interest usually doesn’t apply to the line of credit until you begin borrowing from it.

How are Loans and Lines of Credit Different?

The biggest difference between a loan and a line of credit is the access that each offers you. With a loan, you can only access the funds once. However, with a line of credit, you can access the funds at any time as long as you don’t go over the borrowing limit.

In addition, once you pay back the amount that you borrowed from the line of credit, you can borrow money again and continue repeating this cycle as long as the line of credit is active. Think of it this way: a loan is like a door that you can’t open again once it’s shut whereas a line of credit is a revolving door that you can use again and again.

The other big difference between a loan and line of credit has to do with interest. As we already touched on, a line of credit doesn’t start to accrue interest until you’ve borrowed money from it. Yet with a loan, interest accrues immediately on the full value.

In short, a loan may be better used for a large, one-time cost or for a specific need whereas a line of credit can be beneficial for ongoing, smaller expenses due to its flexibility.

How are Loans and Lines of Credit Similar?

Although a line of credit may not charge you interest right away, do not make the mistake of thinking that it will never charge you interest. Both loans and lines of credit accrue interest that you will have to pay back alongside the amount that you borrowed. The only difference is the time it takes for that interest to accrue.

Similarly, both loans and lines of credit can appear on your credit report and have an impact on your credit score. As long as you manage your loan or line of credit responsibly by making payments on time, then they may have the potential to help build up your credit.

Lastly, both loans and lines of credit offer secured or unsecured options. A secured option means that the line of credit or the loan is backed by collateral, which is a valuable asset that can be seized if you fail to repay the amount borrowed in full. For example, a business could offer equipment, real estate, or inventory as collateral. On the other hand, an unsecured option means that the loan or line of credit does not involve any form of collateral and its amount may be based just on your creditworthiness. In addition, interest rates on unsecured lines of credit or loans tend to be higher than those for a secured line of credit or a secured loan.

Summary

Loans and lines of credit each offer benefits and disadvantages. It’s important to be educated on both and examine your own borrowing needs before deciding which one may be right for you. Similarly, be sure to meet with a financial advisor such as your friends in finance at FFB to determine if you are a good candidate for a loan or for a line of credit. Either way, we’ll be sure to help figure out the right financial solution for you so that you can get your business up and running!