Updated: Aug 17, 2022
The finance industry, just like any industry, has another language that can sometimes be hard to understand. One common mistake people make is using “term loans” and “revolving loans” interchangeably. While they might be similar in that they give businesses access to capital, they are significantly different.
A term loan is a monetary loan that gets repaid over a specified amount of time, usually in fixed payments. Many times, term loans are used for businesses that need cash for their day-to-day operations or for purchases they do not have the money for yet. The borrower is given the money in a lump sum and is obligated to pay it back based on the agreed-upon terms. These loans are generally collateralized by the assets of the business and, sometimes, real estate; however, there are some that can be granted without collateral. Fixed payments are generally made monthly with a fixed interest rate. If the business needs more money than initially received, it will need a second loan.
Term loans are great since they allow businesses to secure the capital they need in a lump sum to be used toward any aspect of the business. This loan comes with a predictable payment and terms that their cash flow can support. In most cases, term loans are repaid in five years; however, they can go as high as 10 years.
Although receiving the money in lump sum might seem like a good choice, it is often difficult to get a second loan, impacting the cash needs and growth of the company. If a business is tight on cash, it is harder to access more money until its first loan is repaid. Many times, there is a caveat in the loan agreement that prohibits the borrower from taking out another loan from another lender without permission from the initial lender. In other words, the borrower would need to get approval from the first lender to get a second loan.
Line Of Credit
A line of credit, commonly called a “revolver,” is an amount of money that a business can “draw” on to use toward its business. This loan is more flexible, as it gives businesses access to capital that is repaid over a predetermined amount of time, like credit cards. As the business makes draws, it is only obligated to repay the principal and interest on it. For example, if a line of credit offers up to $100,000 and the business draws $30,000, it still has access to the other $70,000 whenever it chooses. It is only responsible to repay the $30,000 borrowed and interest. If the business pays down $10,000 of the $30,000, it will then have $80,000 accessible to borrow. When it fully pays back the $30,000, its available money to borrow goes back to $100,000.
A line of credit can be taken out in three ways:
1. Unsecured Line Of Credit: An unsecured line of credit is taken out against the entire business. Rates and terms are determined by the time in business and the company’s credit history and do not require any collateral.
2. Secured Line Of Credit: A secured line of credit uses real estate or liquid assets as collateral. The lender evaluates a property’s loan-to-value (LTV) and lends based on its lendable equity. Generally, real estate has a 70% LTV.
LTV is the amount of lendable equity in a property. This is different from the real equity as lenders want to create a buffer as collateral. An example would be: A building is valued at $1,000,000 with $200,000 owed on the property. A lender is willing to lend 70% LTV, so the value of the property becomes $700,000 minus any money owed. So, minus the $200,000 owed, the final LTV and what the lender will lend is $500,000.
3. Secured By Invoices: This line of credit uses invoices of a business as collateral, otherwise known as factoring or accounts receivable financing. The lenders are looking at the quality of the creditors, not at the financial stability and creditworthiness of the borrower. They lend based on the businesses that are responsible to pay the invoices. This is good for a business since it frees up assets and any lien will fall onto the invoices. This is especially helpful for businesses that deal with cyclical seasons, where some months may bring in more money than others, leading to months where they need capital to operate.
Invoices can take 30-plus days to get paid, making it hard for businesses to operate without cash on hand. Therefore, a lender will generally advance 85% on the current outstanding invoices’ values so that they can run operations without having to wait to get paid. The amount of money available to the borrower changes daily based on the number of invoices they have available. The availability of money increases as the number of invoices increases and decreases as they get paid down.
A line of credit is a great choice since it makes money available to businesses as they need it and interest is only paid back on the outstanding principal. As the loan is repaid, it gives borrowers more money to borrow without having to take out another loan.
However, a line of credit is limited to the collateral or invoices a business has. If a business needs to take out a loan that exceeds its assets or invoices, this would not be the right fit. Also, if a business has an unsecured line, it cannot increase the amount of money available to them unless there is a substantial increase in the business. Therefore, the loan type might not be ideal for a business looking for substantial capital to fuel growth.
Term loans and revolving loans can be great solutions to helping businesses. Although people tend to use them interchangeably, the loans are very different. Both have their advantages and disadvantages; however, neither loan is necessarily better than the other. It all comes down to the needs of the business.
The information provided here is not investment or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Written by Phil Dushey, CEO and President of Global Financial
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