Loan versus Line of Credit

July 28, 2014

We know money is green, and in the eyes of an entrepreneur, money is money. They don’t really care where it comes from or what color it is. But when they have it, they put it into a business to make more from it. Understandable, and fundamentally correct. When capital is required to start or grow a business, one doesn’t really care where the money comes from, they just need it, even if it’s a loan…or a line. What’s the difference?

Difference exists, and is important to understand. It’s important for the community on a smaller scale, and the economy on a larger. Let’s simply discuss some key characteristics and differences of each: Loan is usually a long term debt, used for a specific purpose (huge—Lenders want to know exactly what you need the money for), and paid back in the same amount on a monthly basis, whereas, Line of credit is used multiple times, for various purposes, and paid back in the amount of money used from the limit. Loans are best for long term purposes such as business acquisition and renovation, and Lines of credit are best for short term purposes such as financing receivables and making payroll.

For example: Needing money when buying a property necessitates a different risk assessment, from perhaps, requiring money to meet payroll because the client is due to pay an invoice in another 45-90 days. Money is required in both cases, but when it comes to how the Lender will get paid back, the Lender has to assess both scenarios differently.

The whole risk assessment process (industry, experience, credibility, historic returns, etc) is a lot more complex now than it was in the early 2000’s, in my opinion. Lenders were not focusing so much on controlling risks then, which often led businesses to not be able to pay back. After realizing the continuous mistakes in the financial world, Lenders had to double check their underwriting standards and their distribution of funds. The point I am making with this background of why the risk assessment process is so complex, is that Lenders want to know whether the borrower is utilizing the money appropriately or if they will be able to repay the debt. This complexity takes place for both Loan and Line of Credit processes.

There is a terminology referred to as Use of Proceeds in the financing world, which in simple terms it means, “what do you need the money for”. Only after understanding the uses, will the Lender be able to determine how you will be able to get the money—through a loan or a line of credit.

Returning back to our example: If it is determined that a business is doing well and there are adequate profits on financials to sustain loan payments, then the risk is minimized, and a Lender would take a more conservative approach to issue a loan in this case. If it is determined that an A/R based business needs money to meet small term payroll costs, then the Lender would most likely issue a Line of Credit. This is perceived a little morerisky by Lenders as the business will pay back once they get paid by their clients, within 45-90 days that is.

All of this can seem overwhelming, especially since banks are approving a single-digit percentage of the applications they get from entrepreneurs. For now, take a deep breath and learn if you’ll need a Loan or a Line of Credit.