Revolving Credit vs. Term Loans: Which is Better for Small Business Owners?

Every entrepreneur has to make important financial choices along the way to operate their small business. Whether it is managing cash flow swings with seasonal fluctuations or investing in a large growth, choosing the right financing alternative will decide your enterprise’s success.

We are frequently asked to contrast revolving credit facility vs term loan, as these are two of the most common forms of small business financing. Each is for a different purpose and has its own benefits as well as limitations.

Remember, common business financing scenarios include:

Term loans work best for big, long-term investments. We see firms choosing term loans when they need funding for essential equipment, machinery, or vehicles. Medical practices use term loans, for instance, to finance expensive diagnostic machinery, and construction companies use them to purchase heavy machinery.

Conversely, revolving credit facilities excel at accommodating seasonal fluctuations. We’ve seen that retail businesses especially use this option when they must prepare and secure inventory levels before peak times or manage cash flow during slow seasons. Revolving credit affords flexibility with amounts from $250,000 to $2M, and with multiple drawdowns, they can be repaid or re-drawn.

In the table below are frequently seen examples of each option that would work well for your needs:

• Term Loans Best For:

o Equipment purchases and machinery replacement

o Real estate acquisitions

o Long-term business growth initiatives

o Debt consolidation

• Revolving Credit Best For:

o Financing seasonal inventory buys

o Covering unexpected operating costs

o Covering short-term cash flow shortages

o Aiding short-term growth opportunities

The key difference lies in the purpose: term loans help finance specific, one-time purchases, while revolving credit provides ongoing flexibility for fluctuating business needs. We’ve noticed that businesses often maintain both types of financing to address different aspects of their operations effectively.

Evaluating Cost Implications

Understanding the true cost of business financing requires looking beyond just the interest rates. We’ve found that both revolving credit facilities and term loans come with distinct cost structures that can significantly impact your bottom line.

Term loans have lower interest rates, ranging from 6.42% to 12.41% in banks. Revolving credit facilities have variable interest rates starting with Prime Rate plus 1.50% or more. But the real cost story goes beyond interest rates. Here is another sad anniversary.

With revolving credit facilities, we have a golden advantage: you only pay interest on what you’ve drawn, and not on the entire credit limit. This can be very cost-saving if you’re smart with your drawdowns. Keep in mind that these facilities may come with additional charges:

• Annual maintenance fees
• Draw fees when utilizing the funds
• Commitment fees for maintaining the credit line open

Term loans, while they offer more definite costs, have their fee structure. We typically see origination fees ranging from 1% to 6% of the loan. The total cost of borrowing should cover:

• Expression and processing charges
• Underwriting charges
• Closing charges

To achieve an accurate comparison, we always recommend comparing the Annual Percentage Rate (APR), including interest and fees. That is a better indicator of the true cost of borrowing. For instance, an apparently great 10% interest rate may turn out higher when you add other charges in the APR. 

Strategic Implementation Tips

We’ve helped numerous businesses navigate the loan application process, and proper preparation is crucial for success. Let’s focus on how to effectively implement your financing strategy, whether you’re considering a revolving credit facility or term loan.

Documentation Preparation is your first priority. Based on our experience with successful applications, you’ll need:

• Financial statements and tax returns from the past three years
• Current bank statements and income documentation
• Business formation documents and licenses
• Detailed business plan with projections

Your credit report plays a significant role in the approval process. We recommend checking your credit score before applying – a 700 or higher tends to yield the most favorable results. For lower scores, we recommend taking action to improve your credit before submitting applications.

When preparing your application package, be thorough but efficient. We’ve found that applications with complete documentation are processed significantly faster – sometimes in just 60-90 days compared to longer processing times for incomplete applications.

Don’t lose track of potential lenders. We suggest you return calls or respond in a timely manner if a lender requests more info as it can help speed-up your approval process. Also, take advantage of the perks of working with SBAA Preferred Lenders when applying for an SBAA loan because they usually have the ability to make the process quicker.

Conclusion

When choosing between revolving credit and term loans, it will really depend on your unique business requirements and business objectives. Term loans have the demonstrable stability of lower interest rates and provide the best opportunity for larger purchases. Revolving credit provides flexibility for day to day operational needs and seasonal fluctuations.  We have seen successful businesses utilizing both products, and often times sharing both to provide the most information across a full range of financing options inclusive of both term and revolving.

In deciding between one product and another, it essentially boils down to what prudent planning occurs beyond just the interest rate. Keep in mind that term loans are best for targeted, point in time expenditures while revolving credit is best for steady state essentials. There has to be a pretty good fit between the business model and cash flow profile of the business, and what the ultimate long-term or growth financial strategy looks like.