Advantages and Disadvantages of Business Lines or Loans

Advantages of business lines:

• You can easily obtain an increase in your business line of credit when your business grows.
• Business lines of credit helps businesses manage cash flow, when customers pay invoices one to three months after performing the work.
• You are only paying for the amount used on your line of credit. If your line of credit is for $50,000, but you have only used $10,000, you are only charged interest on the $10,000.
• You don't have to provide a business plan for use of the proceeds.

Disadvantages of business lines:

• There is a temptation to use the business line without a solid plan to repay it.

Advantages of business loans:

• The interest rate is usually lower than business lines.
• When you pay off a loan, your payments stop.
• If you are purchasing equipment, you can improve cash flow by choosing a Section 179 tax deduction for the full equipment (up to $250,000) this year, and pay for the equipment over many years.

Disadvantages of business loans:

• You cannot "increase" a business loan. As your business grows, you can only obtain a new loan or refinance the loan.
• You are paying for the whole loan, whether you use it or not. This is only beneficial if you are using the entire proceeds.

Business line or business loan?

Businesss loans are used for one-time purchases that you will repay over a period of years. This includes equipment, facilities, start-up costs, and property. Business loans are expected to be paid off.

Business loans can be guaranteed by the SBA or other state programs. Business loans also require collateral - either from the owner or the business.

Business lines are used for ongoing purchases that are connected to a sale. Usually inventory and overhead is funded with a business line of credit. Business lines of credit are expected to be used each month, repaid and then used again.

Business lines of credit do not have collateral, but the owners are often asked to guarantee the line. That means if the business fails, the owner agrees to use his/her personal assets to repay the line of credit.

Required collateral and documentation

For loans, most banks require either a personal guarantee or specific collateral. A personal guarantee means if your business assets are insufficient, you will use your personal assets to pay back the loan. For sole proprietors and partnerships, this is irrelevant, since your business debts and personal debts are mixed. However, it is significant for LLCs and corporations, which normally are protected from business debts.

Collateral can be cash, home equity, equipment, receivables, or investments. Banks will also require your business and personal tax returns, business financial statements, and a plan for the proceeds. You will also need to provide a copy of your business formation documents.

Lines of credit are usually based on a guarantor's personal credit, with business financial statements showing the ability to repay. You will need to provide a copy of your business formation documents.

Based on your credit score, banks may require that your collateral be "protected" so it is not spent. You may have to deposit cash into a long-term CD, they may file a UCC statement on equipment so it cannot be sold, or they may place a deed of trust on your home, so they are paid if your home is sold.

Federal SBA or state guaranteed loans

Federal SBA or state guaranteed loans protect the lender from 50 to 80% of any loss on an insured loan. It does not protect the borrower - so if a loan is in default, the entire loan goes against the borrower's credit record.

You get a guaranteed loan through your bank. Each bank has its own lending policies, so if you are rejected by one bank, it does not mean you will be rejected by the bank next door.

Click here for a list of preferred lenders for your area.

Building business credit

You will reach a major business milestone when you are able to get business credit based on your business alone. To do that, you need to build business credit.

Click here for information from the Funding Toolkit within the Tools for Business.

Best Practices

• Know whether you need a line of credit to deal with cash flow timing, or a loan to purchase something over time.
• It is faster, requires less paperwork, and banks make more money by giving you a business line of credit rather than a guaranteed loan. But your interest rate for the loan will be much less for the guaranteed loan than for the line of credit.
• Lines of credit:
  • Use the line of credit for purchases directly connected to your sales.
  • When you receive payments from your customers, pay the amount of your cost of sales towards your line of credit.

Ongoing Responsibilities

With lines of credit, you are expected to:

• Make the monthly payments, paying the line of credit down as you receive payments from your customers
• Limit use of your line of credit for expenses related directly to sales.

With business loans, you are expected to:

• Make the regular monthly payment
• Provide your lender quarterly accounting reports, with a balance sheet and your net profit.