Operating Line of Credit vs Term Loan: 5 Key Differences

Regardless of its size and longevity, any business is bound to experience financial challenges at least once throughout its life – from limited or inconsistent cash flow to poor tax compliance, too much debt, lack of preparation for unforeseen expenses, or not raising enough capital.

When this happens, having access to additional funds is of uttermost importance for the growth of the business. However, considering the variety of financial tools available on the market, it could be challenging to choose the one that fits your needs the best without knowing the key differences between each one.

In this article, we will talk about two of the most common financing options offered by lenders – operating lines of credit vs term loans. What are the main differences between them, and which one is better for your current situation? Let’s take a look:

Operating Line of Credit vs Term Loan: 5 Key Differences

1. Purpose of the funds

When discussing the differences between an operating line of credit vs a term loan, the first key difference is the purpose and the use of the loan. In other words, what is the main reason why companies use it?

Operating Line of Credit –  this type of financing is typically more short-term in nature, and it’s designed to provide access to immediate funds for the day-to-day operations of a business. This often includes:

• Purchasing inventory and equipment
• Covering short-term cash flow shortages
• Paying wages and overhead costs
• Handling unexpected expenses
• Serving as a safety financial net

Term Loan –  as opposed to an operating line of credit, term loans are typically more long-term in nature, and they are designed for specific, often substantial, investment purposes. In other words, a business will usually use a term loan to finance long-term investments, including:

• Acquisition of machinery, vehicles or technology
• Purchasing of real estate property
• Expanding existing locations, or opening new ones
• Consolidating existing debt into a single loan
• Making large-scale inventory purchases

2. Repayment structure

Another key difference when it comes to operating lines of credit vs term loans is their repayment structure, which reflects their distinct uses and purposes.

• Operating Line of Credit – this financial option provides borrowers with a higher degree of repayment flexibility, which means that they can draw funds up to the credit limit, repay, and redraw again as needed – also known as revolving credit.

In addition, the borrower only pays interest on the amount drawn, and not on the whole line of credit that he has been approved for. The repayment amounts tend to be variable since the amount borrowed can vary over time.

• Term Loans – when comparing an operating line of credit vs a term loan, it’s important to keep in mind that term loans work on a fixed repayment schedule, which starts as soon as the loan is disbursed. This schedule dictates regular payments over the term of the loan, which can range from 3 to 20 years.

Payments usually include both principal and interest, and the interest rate can be fixed or variable – which means that they can either be the same amount during the loan’s term, or they can fluctuate with changes in the interest rates. Once the loan amount is disbursed, the borrower can’t access the repaid funds again – meaning the credit is not revolving.

3. Interest rates

Interest rates also have different nuances when it comes to an operating line of credit vs a term loan.

Operating Line of Credit – when taking an operating line of credit, keep in mind that the interest rate is typically variable, and it can range from as low as around prime + 1% to prime + 20% or higher for less creditworthy borrowers.

In addition to your creditworthiness, the interest rate will also depend on the financial health of your business, the length of business operation, whether you are offering collateral (secured vs unsecured line of credit), and the market conditions.

Interest rates for operating lines of credit can fluctuate over time based on market rates, such as the prime rate or LIBOR – which introduces some unpredictability in the cost of borrowing. They are usually higher compared with those on term loans.

Term Loans – when comparing the interest rates of an operating line of credit vs a term loan, the key difference lies in the fact that term loans can have either fixed or variable interest rates. Fixed rates remain constant over the term of the loan, while variable ones can fluctuate with market conditions.

The exact interest rates may vary widely, ranging from as low as 12% to up to 30% for small businesses generally and from 2% to 5% above the prime rate for larger, more established businesses. Less creditworthy companies usually face higher interest rates.

4. Collateral requirements

Operating Line of Credit – when comparing collateral requirements between an operating line of credit vs a term loan, one key thing you’ll have to know is that operating lines of credit can be two types: secured and unsecured.

Secured lines of credit require collateral as a guarantee against loan defaulting, which can include real estate, accounts receivable, inventory, or other valuable assets. Because the collateral provides additional security for the lender, you can expect lower interest rates and higher credit limits. It may also be easier to qualify for.

Unsecured lines of credit are not backed up by collateral, which means that there is no added security for the lender against default. This may result in higher interest rates, lower credit limits, and they may be harder to qualify for as you’ll have to show a stronger credit score and a solid business revenue, among other factors.

Term loans – Collateral requirements are generally the same for term loans as they are for operating lines of credit. Businesses that offer collateral often receive more competitive rates and terms because their asset assumes some of the lender’s risk.

5. Flexibility and access to funds

Another key difference when comparing an operating line of credit vs a term loan is the flexibility of the loan and the ease of access to funds.

Operating Line of Credit – operating lines of credit are associated with high flexibility compared with other financial tools, as they allow you to draw funds up to a certain limit at any time within the draw period.

This makes them highly convenient for managing cash flow fluctuations, converting short-term operational costs, or addressing unexpected expenses. In addition, the funds can be accessed repeatedly as long as the borrower doesn’t exceed the credit limit and consistently repays the borrowed amount.

Term Loans—When it comes to flexibility, the main difference between an operating line of credit and a term loan is that term loans are one-time, lump-sum payments. Businesses have access to the full amount starting on the first day of their term. If they need additional funds during their repayment, they’ll need to take out another loan entirely.

What Are the Main Differences Between an Operating Line of Credit vs a Term Loan?

So, how can we sum up the key differences between an operating line of credit vs a term loan? Let’s take a quick look at their distinctive nuances:

An operating line of credit offers flexible access to funds up to a specified limit for short-term needs and is revolving, allowing borrowers to draw, repay, and redraw as needed, paying interest only on the amount used.

A term loan provides a lump sum amount upfront for long-term investments, with a fixed repayment schedule over a set period. Term loans are suited for significant, one-time expenditures, offering stability but less flexibility compared to lines of credit, which support ongoing operational cash flow needs.

Is An Operating Line of Credit or a Term Loan Better For Me?

While both financial options are great for providing additional access to funds for your business, sometimes one option is better than the other, especially depending on your particular financial situation.

Opt for an Operating Line of Credit if you:

• Need funds to cover short-term financial needs, such as managing cash flow fluctuations, seasonal demands, or unexpected expenses.
• Want to have extra financing for ongoing operational expenses, such as purchasing inventory or covering payroll.
• Prefer not to have a fixed monthly payment on the full loan amount, and instead pay interest only on the amount used.
• Need flexibility when it comes to drawing funds, and may not need the full amount right away, but want to have it as a financial safety net.

Opt for a Business Term Loan if you:

• Need funding for a long-term investment, such as purchasing equipment, real estate, or financing major expansion projects.
• Have a specific project with a clear cost that likely won’t change.
• Prefer predictable monthly payments that include interest rates and principal, which helps with budgeting and financial planning.
• Want to reap the benefits of lower interest rates for long-term financing.

Applying for Financing With National Business Capital

Whether you are looking for an operating line of credit or a term loan, look no further than National Business Capital. With a single application, you can get access to dozens of exclusive offers from our diverse lender platform so you can make the best decision for your business.

With $2+ billion financed since 2007, multiple awards, and an experienced team of Business Finance Advisors, we have everything you need to find the best financing options for your project.

Are you ready to get started? Apply here.