A line of credit (LOC) is usually considered a short-term loan. The payments are interest-only, based on the outstanding funds in use. As you draw down on the line, using it to pay bills, interest is accrued monthly. The line is like an open checkbook for ‘use as needed’ purposes. The critical nature of the LOC is the necessary discipline to put funds from income back to pay down the line. There should be a constant flow of money coming from the line to pay bills and then replenished as customers pay for your goods or services.
When applying for the LOC, the bank is typically looking for historical cash flow. What does the revenue look like? Is it steady or fluctuates wildly? The bank will take a conservative view of the existing accounts receivable to get a baseline. For the most part a bank will not be able to consider potential new business when considering a LOC credit limit.
A term loan is a fixed funding transaction. It is a one-time loan based on cash flow of the business plus certain collateral pledged against the loan. The loan should be used for a major expenditure rather than daily cash flow for the business. All the proceeds are available at the time of closing, not like a line where funds are circulating. The payments are interest and principal based on the amortized terms of the loan. (For example, a $100,000 loan at 8% interest over a 5-year term.)
The bank will assume an ownership position on the collateral, meaning the collateral cannot be transferred or liquidated. The historical cash flow of the business is critical to securing a term loan. The lender needs to see that loan payments will not have an adverse affect on the business operations. Term loans are used to purchase real estate, equipment, for build-outs, or franchising.
There are situations where a LOC that has been used to the credit limit is converted into a term loan, so the business will have to make monthly payments to pay off the old line. The problem becomes the business no longer can gain access to additional funds while the loan is outstanding. Access to capital is the lifeblood of any company, and lack of capital will starve a growing business.
Gary Honig is the President of Creative Capital Associates, a nationwide source of working capital since 1997. He can be found at http://www.ccassociates.com.