When checking out options for financing your small business’ cash flow needs, it’s important to know the difference between a business loan and a line of credit.

A loan is pretty easy to understand, though the paperwork and legal boilerplate may be more than a bit confusing. The lender gives the borrower a set amount of money, to be repaid over a period of months or years. In exchange for the loan, borrower pays interest on monies received. That's the incentive for the lender to hand over the cash in the first place. The lender puts its money to work, earning interest paid by the borrower.

A line of credit can have numerous benefits to borrowers. Here's an example:

Your bank approves your company for a $50,000 line of credit. That means your company can borrow up to $50,000, but isn't required to borrow that amount.

With a line of credit, your business has flexibility to choose when and how much capital to use. For instance, your company may decide to draw $5,000 on its $50,000 credit line. In that case, your monthly payment and interest charge is based on the $5,000 actually borrowed, not on the entire $50,000 credit line, which can save you a lot on interest payments.

In subsequent months, if you draw more from the credit line, your payments will increase along with interest charges. You can pay back and "re-borrow" from a credit line to provide a cash cushion whenever your business needs it.

In the case of a loan, funds are disbursed upfront, and interest on the entire loan amount is due each month, whether your business uses the capital or not. A credit line is used when funds are needed and for whatever reasons company management deems appropriate for business growth.

Which type of credit is right for your company?

  • Term loans give your company the full loan amount up front. The money is then repaid in prearranged monthly installments throughout the term of the loan. The term of a commercial loan typically ranges from one to 15 years.

Interest is charged on the outstanding balance of the loan, and the interest rate is usually (but not always) fixed. Term loans make sense when a company needs funds for a specific purpose: an equipment purchase, capital improvements, facilities expansion, marketing and other business expenses. Think of a term loan as an "I know what I need and when I need it" loan.

  • Lines of credit give your company the option of borrowing as much money as you need, when you need it, up to a pre-arranged maximum amount.

Interest is charged on the outstanding balance and not on the unused portion of the line of credit. Interest rates are almost always variable and are tied to a standard index like the prime rate. Think of a line of credit as an  "I know I'll need funds but I'm not exactly sure when" loan.

Qualifying for a line of credit may be more difficult than qualifying for a loan. A loan made to purchase equipment or to purchase a facility, for example, uses that equipment or facility as collateral to cover the loan amount in case the company defaults and is unable to repay the loan.

With a line of credit, the choice of how funds are used is left to the discretion of the borrower. Therefore, the lender assumes more risk because the borrowed funds may or may not result in collateral sufficient to secure the loan.

How does your business qualify for a line of credit?

A good business credit rating and a solid, company financial history are required. Few lenders will approve lines of credit for start-ups or businesses without a track record of financial success. Be prepared to provide financial documentation like profit-and-loss statements, balance sheets and company tax returns when applying for a credit line.

Many lenders also require other collateral to secure a line of credit. A business line of credit is almost always asset-based, with hard assets like equipment or facilities used as collateral to back the credit line. Credit lines can also be secured by receivables or business inventory.

Deciding whether to choose a line of credit or a term loan should be based on how much capital you need, how long you need it, and when you can pay it back. A line of credit can be paid down any time. So can a commercial term loan through an accelerated payment plan that doesn't penalize your business for early payments.

Talk to the commercial loan officer at your business bank to determine whether a credit line or a term loan is right for your business.

Think ahead and plan how and when the infusion of capital will be used and for how long. The decision becomes simpler when you, the business owner, know how the capital will be used.

Click here for information about business loans or lines of credit from Nevada State Bank.

The information provided is presented for general informational purposes only and does not constitute tax, legal or business advice. Any views expressed in this article may not necessarily be those of Nevada State Bank, a division of Zions Bancorporation, N.A. Member FDIC