Working capital loan vs line of credit: which one is better for your business? Continue reading to learn more!

Business owners who are considering financing have numerous options ahead of them, so much so that it’s often challenging to decide which one is most beneficial for their circumstances.

Some are more useful for specific situations, such as equipment financing for a business looking to purchase a new truck, tool, or machine, whereas other solutions are more general in their terms of use.

Someone who is looking for extra capital to cover day-to-day expenses might consider a business line of credit or working capital loan, but these options have some key differences that could make one more beneficial for your situation over another.

Rather than spend hours researching both of these financing options, we’ve made it easy for you. Read on below for all the information you need to know about working capital loans and business lines of credit:

1. What is a working capital loan?

So, what is a working capital loan? Let’s take a look:

A working capital loan is a lump-sum payment that a business can use to cover daily expenses. They can’t be used to purchase equipment or long-term investments, but they can be used for items in the short-term, such as payroll, rent, or any outstanding debt payments your business is dealing with.

Much like any other loan, you pay back the capital in monthly installments based on the terms you agreed to. If you end up needing additional capital, you’ll need to take out another loan on top of your existing one, which can turn into a headache if you’re busy running your business and don’t have the time to call your lender regularly.

Working capital loans are beneficial for any business or organization that deal with cyclical or seasonal sales, such as manufacturing companies. Typically, manufacturers sell more products during Q4 because of the holidays, and they might not be able to cover their daily expenses as they increase production during the months of Q2 and Q3.

Small businesses might consider a working capital loan to help cover their expenses in the interim of their sales to pay their employees, pay rent, or pay off an outstanding debt they accrued during one of their down months.

There isn’t an equity transaction requirement with working capital loans, meaning that you will continue to hold full control of your company throughout repayment. Additionally, these loans are frequently tied to your personal credit, and any late payments or defaults will negatively affect your credit score.

2. How can you use a working capital loan?

Before we evaluate the pros and cons of a working capital loan vs line of credit, let’s see the use cases for a working capital loan:

Let’s recap: You can use a working capital loan for:

  • Covering seasonal decreases in revenue
  • Managing short-term cash flow
  • Bridging the gap between payment delays
  • Payroll and rent payments
  • Unexpected costs
  • Other short term expenses, such as a marketing campaign

Working capital loans are great if you need a lump-sum payment to mitigate ongoing expenses or prepare for unforeseen costs that may occur down the line. However, you should remember that this option is a loan, and you’ll have all the benefits and shortcomings that a loan will bring.

3. What is a business line of credit?

A business line of credit is more similar to a traditional credit card than a loan. Rather than receive a lump sum payment as you take out a loan, a business line of credit is a revolving line of credit for a specific amount that you can draw on at any time within the term.

Working capital loan vs line of credit. Source: wallstreetmojo.com

You pay interest on the capital you take instead of the total amount, which offers a flexible option for businesses looking for short-term funding or to safeguard against unexpected expenses.

Whether you need to cover a seasonal downturn in sales or a rainy day fund, a business line of credit can help you without shackling you with strict requirements.

As soon as you pay down the balance on your line of credit, you can draw funding again and return to paying interest on what you’ve taken. You’ll likely have your credit reviewed before the line of credit is opened for you, and you might have to pay fees for specific circumstances depending on your lender.

Starting a business line of credit also comes with associated costs, which are traditionally more expensive than taking a loan out for your business. For the best experience with business lines of credit, you should avoid any lender that doesn’t offer transparent information about fees and guidelines.

Much like a working capital loan, business lines of credit also come in two forms: secured and unsecured. Secured loans are backed by collateral, while unsecured loans are insured by a lien or personal guarantee.

Putting an asset up as collateral is risky, especially if you aren’t 100% sure you’ll be able to repay the loan within the terms. If a lender is only offering secured business lines of credit, it might be time to find a lender with more options.

In some cases, lenders will require you to have a 0 balance for a period of time during your terms. This can be anywhere from a few days to a few months, but this limits your ability to use the credit line you’ve signed on for.

You might also have to submit collateral to be eligible for a business line of credit if your credit score isn’t the best, so be sure to have that in mind before making any final decisions.

4. Business lines of credit vs business credit cards

While they might sound similar, business lines of credit aren’t the same as business credit cards. Credit cards generally charge higher interest rates, whereas a line of credit will usually have a lower interest rate and better amortization schedule.

Additionally, a business credit card is only used for transactional purchases. If you need to draw cash quickly, a business credit card won’t help you much, but a business line of credit allows you to take the capital you need at a moment’s notice.

5. What can you use a business line of credit for?

Once again, before we dive into the pros and cons of working capital loan vs line of credit, let’s recap: You can use a business line of credit for:

  • Covering short-term expenses, such as payroll, rent, and other costs
  • Bridging the gap between periods of low revenue
  • Purchasing inventory/supplies
  • Repairing equipment/vehicles
  • Launching a marketing campaign
  • Renovating a room in your facility

Business lines of credit offer increased flexibility but come with higher start-up costs. However, you can use a business line of credit for almost any business expense, although it’s recommended that you use it sparingly and avoid taking on longer-term investments.

6. Secured vs unsecured

When speaking about a working capital loan vs line of credit, it is important to know that they are broken down into two categories: secured and unsecured. Your credit score will likely determine which one you’re eligible for, but the terms you choose and the amount the loan is for will also play a role.

6.1. Unsecured

A unsecured working capital loan requires no collateral, so you won’t have to risk losing the chosen asset if you default on the loan. However, if you do default on the loan, the lender is entitled to collect the amount owed.

Unlike traditional collateral, you back your unsecured loan with your accounts receivable, as you’re showing the lender that you’re capable of paying back the loan with your own revenue. Unsecured working capital loans often come with higher interest rates because the lender assumes more risk than a secured loan.

6.2. Secured

If your credit score isn’t high enough to be eligible for an unsecured loan, you’ll be required to offer some form of collateral to secure the loan.

This can include real estate, equipment, and other valuable, tangible assets, but you should remember that you’ll lose that asset if you fail to repay the loan. Secured working capital loans come with lower interest rates because of the collateral requirement, which can help business owners who are looking for lower-cost options.

7. Working capital loan vs line of credit

Pros and Cons

Before we break into which option is best for your specific situation, let’s take a look at the pros and cons of both options:

7.1. Working capital loans

Pros:

  • Easy to obtain
  • Low start-up cost
  • Might not need collateral
  • Allows you to cover gaps in revenue, whether seasonal or cyclical
  • No equity transaction
  • Borrow and repay quickly, depending on your terms
  • Ability to cover short-term costs and prepare for unforeseen expenses
  • Almost unrestricted use of funds, depending on the lender

Cons:

  • Need to repay the entirety of the loan, including interest
  • Potentially short repayment terms, depending on your lender
  • Might need to offer collateral
  • Higher interest rates
  • Might affect your personal credit score if you default

7.2. Business line of credit

Pros:

  • Flexible funding allows you to take as much as you need from your line
  • Pay interest only on what you draw
  • Build a relationship with the lender
  • Ability to pay off your balance and draw more funding based on your needs
  • Builds business credit history
  • Might not need to offer collateral
  • Allows you to cover gaps in revenue, whether seasonal or cyclical
  • Ability to cover short-term costs and prepare for unforeseen expenses
  • Unrestricted use of funds

Cons:

  • Potentially high fees depending on the lender
  • Difficult to qualify with a low credit score
  • The need to monitor and ensure you aren’t approaching the maximum limit
  • Strict eligibility requirements
  • Might need to offer collateral
  • Low borrowing limits might not work for some circumstances

Working capital loan vs line of credit: which financing option Is better for me?

Choosing between a working capital loan vs line of credit will depend on your circumstances. You’ll need to take a second and lay out all of your organization’s needs and base your decision around that.

If you’re a seasonal business that sees the most profit in a few months during the year, either option can allow you to cover the daily expenses of your business while you wait for the more profitable months.

However. if you need a larger sum of capital, you should consider a working capital loan. In contrast, an organization that doesn’t need the lump sum and would benefit from extra capital at a moment’s notice might want to choose a business line of credit.

If you’re trying to save your business from falling into the red, a business line of credit might not be the best option for you. You’ll still need to pay off the existing balance on your line of credit even if your business fails, which can add even more stress to an already frustrating situation.

However, the same applies to working capital loans, as you might lose the asset you put up for collateral if you default on the loan.

You might already know which option is best for you, but everything can change depending on the lender you’re dealing with. Some lenders will require collateral, whereas others might want you to pay expensive fees before you’re able to access the capital.

This can make your search for financing even more difficult, as you’ll likely have to speak with a few lenders before you find one with terms that meet your needs. Not only that, but Rather than waste your time, you can team up with a company with a vast marketplace of lenders, one like National Business Capital.

Finance your business with National and find the most opportunities in one place

At National, we’ve streamlined your financing journey and created a system that connects you with the funding you need in as little as a few days. Our 75+ marketplace gives you options, which is something that you won’t find at a bank or traditional lender.

There might be thousands of other marketplaces out there, but no one does it with the same quality and consistency as National. We don’t want you to accept the first loan you find; We’d rather work with you until we find a solution that can allow your business to grow and prosper.

We heavily invest in our client’s experience to ensure that you won’t waste time that you could have spent on running your business. Our team is there for you before, during, and after the deal is done, giving you peace of mind that your business is in the best of hands.

And, don’t forget; We donate 10 meals to Feeding America for every deal we fund.

Ready to see your options? Apply now to get started.