Introduction
"Line of credit or term loan?" is one of the most common financing questions small business owners face, and the honest answer is: it depends entirely on what the money is for. This guide breaks down the real structural differences, when each one actually fits, and the cost tradeoffs that matter more than the headline interest rate.
Table of Contents
- The Core Structural Difference
- How a Line of Credit Works
- How a Term Loan Works
- Cost Comparison: It's Not Just the Rate
- When to Use Each
- Using Both Together
- FAQ
- Conclusion
The Core Structural Difference
| Line of Credit | Term Loan | |
|---|---|---|
| Disbursement | Draw as needed, up to a limit | Lump sum, all at once |
| Interest | Only on the amount drawn | On the full amount from day one |
| Repayment | Flexible, revolving as you repay | Fixed schedule, set term |
| Best for | Ongoing or unpredictable needs | A specific, one-time expense |
| Typical rate | Often variable | Often fixed |
How a Line of Credit Works
A line of credit works more like a credit card than a traditional loan: you're approved for a maximum limit, and you draw only what you need, when you need it. Interest accrues only on the drawn balance — an undrawn $50,000 limit costs you nothing in most cases beyond a possible small unused-line fee. As you repay what you've drawn, that capacity becomes available again, which is why it's called "revolving" credit.
This structure makes a line of credit particularly well-suited to smoothing out cash flow gaps — covering payroll during a slow month, bridging the gap between an invoice going out and payment actually arriving, or handling a seasonal dip — situations where you don't know exactly how much you'll need or when.
How a Term Loan Works
A term loan is more straightforward: you receive the full approved amount as a lump sum upfront, and you repay it on a fixed schedule (monthly, typically) over a set term, with interest calculated on the full principal from day one. Once repaid, the loan is closed — there's no revolving availability like a line of credit.
This structure fits specific, one-time expenses where you know the exact amount needed upfront: buying equipment, funding a defined expansion project, or a planned inventory buy ahead of a known demand spike.
Cost Comparison: It's Not Just the Rate
The headline interest rate isn't the whole story:
- A term loan often has a lower nominal rate, but since interest accrues on the full amount immediately, the total cost is locked in regardless of whether you needed all the capital right away.
- A line of credit can be cheaper in practice if you don't draw the full limit — you're only paying for what you actually use, which suits unpredictable or partial needs.
- Always compare APR, not just the advertised rate — origination fees, draw fees, and unused-line fees all affect the real cost, and these vary significantly between lenders and products.
When to Use Each
Use a line of credit when:
- You need a flexible buffer for unpredictable cash flow gaps
- The exact amount and timing of the need isn't known in advance
- You want to minimize interest cost by only borrowing what you actually use
- You're managing seasonal revenue swings
Use a term loan when:
- You have a specific, known expense (equipment, expansion, a defined project)
- You need the full amount available immediately
- You want a predictable, fixed repayment schedule for budgeting purposes
- You're financing something with a clear ROI timeline that matches the loan term
Using Both Together
Many established businesses maintain both: a term loan for planned, larger capital investments with a known timeline, and a line of credit kept open as a standing buffer for unpredictable short-term needs. This isn't redundant — each serves a genuinely different purpose, and having the line of credit already established (rather than applying for one during an actual cash crunch) is a real resilience advantage, since lenders evaluate risk far more favorably when a business isn't already under financial pressure.
Conclusion
The choice isn't about which product is "better" — it's about matching the structure to the actual need. A predictable, one-time expense fits a term loan; an unpredictable or ongoing cash flow buffer fits a line of credit. Get this match right and you'll pay less in total financing cost than defaulting to whichever product a lender pitches first.
If you'd like help figuring out which financing structure actually fits your cash flow pattern, get in touch for a free consultation.