Line of Credit or Personal Loan: How to Choose

Small Business
Line of Credit or Personal Loan: How to Choose

Entrepreneurs looking for cash injections to boost their businesses have a wealth of options these days. Despite the increasing popularity of crowdfunding and peer-to-peer lending, small-business owners can still call upon some of the more traditional sources of financing, such as bank lines of credit and personal loans, to help them expand.

Despite the similarities between lines of credit and personal loans, there are also a number of key differences. Here’s a closer look at when to choose one over the other, as well as how the repayment and application processes compare.

The basics

Business owners typically turn to traditional loans when they need funds for a one-time purchase that they wouldn’t be able to afford on their own. For example, a clothing company might apply for a loan to help buy and install new equipment to increase production. While this kind of loan might surpass six figures, not all loans have to be used for such ambitious projects, and the loan amount could be as low as $3,000.

Lines of credit, on the other hand, are typically used for recurring expenses, such as restocking inventory and paying employees. Business owners can pull money from the line of credit they’ve been issued whenever they need to. Whoever issues the line of credit, be it a bank or a credit union, limits how much money an individual can borrow each month.

Repaying loans vs. lines of credit

Before being extended a loan, a small-business owner works with the lender to draw up a repayment schedule. This will determine the length of the loan, its interest rate and the monthly amount that the small-business owner has to pay the lender. Unlike a line of credit, a loan will need to be repaid starting immediately, regardless of whether any funds have been used.

In a line of credit, you only make payments on the amount of money you’ve used, and you’re typically given a month to repay at least a portion of what you borrowed. Although not every line of credit is the same, most typically ask for a minimum payment of 1% or 2% of the total amount you borrowed. Much like paying your credit card bill, it’s always a good idea to pay all or as much as possible each month to avoid racking up debt. Since the amount of money you pull from your line of credit will likely change month by month, you won’t be making fixed payments.

Because you can pull from the same line again in the following month, these financial products are often called revolving lines of credit. Your issuer will require you to make good on any outstanding debt at least once or twice a year. Lastly, lines of credit usually have a life span of one or two years, after which the institution that’s extending you credit can renew or terminate the line.

How to obtain each product

Both banks and credits unions offer loans and lines of credit. To evaluate the chances of defaulting on your loan, these financial institutions will run thorough background checks on your personal and business credit histories and past borrowing behavior. You’ll only be offered the best interest rates if you have a strong FICO credit score of at least 700. A credit score of 630 or below could disqualify you.

If your business lacks a proven track record of success but your credit score is strong, a lender may ask you to put up collateral, especially when applying for a line of credit, according to Craig Smalley, a small-business lending expert.

“A line of credit is usually tied to an asset for collateral,” Smalley says. “For instance, most lines of credit that small-business owners use are second mortgages on their homes,” meaning the collateral is the home.

“Sometimes, a small business is able to secure a line of credit with the collateral being the assets of the business,” Smalley says.

The takeaway

Although personal loans and lines of credit can each provide the financing your small business needs, they aren’t interchangeable. Consider a personal loan if you need funds for a one-time purchase, as this will give you time to repay the loan over an extended period of time. If, on the other hand, you need money for monthly expenses you know you can pay back on a regular, ongoing basis, consider pursuing a line of credit.

Also, if you’re asked to put up collateral for a loan, proceed with caution. If you default on the loan, you could lose your property.

For more information about how to start and run a business, visit NerdWallet’s Small Business Guide. For free, personalized answers to questions about starting and financing your business, visit the Small Business section of NerdWallet’s Ask an Advisor page.

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