Lines of Credit
Lines of credit are typically provided to businesses by banks or credit unions. They provide the borrower with the most flexibility by allowing them to borrow and repay funds as needed. This can help a borrower reduce their total interest expense by reducing the total amount of the outstanding balance throughout the year. In addition, the interest rate for lines of credit is typically lower than a similar fixed-rate/term loan. For example:
Your business just received a large order from a new customer. To meet this order, you need to purchase $100,000 of materials from a supplier that isn’t willing to extend terms/credit. Your business has been doing well, but you weren’t planning on getting this order. You expect to have a healthy profit in about 5 months when the order is complete and you receive payment from your customer. This could be a great opportunity to use a line of credit rather than a fixed-rate/term loan. The line of credit would allow you to draw funds as you need them (maybe you need $60,000 up-front to buy materials from the supplier and another $40,000 in 2 months to pay for labor to produce the product) and repay the line of credit when you receive payment from your customer. Typically, a line of credit will remain active (even with a $0 balance) so you would be able to use it in the future, too. If you had chosen to use fixed-rate/term financing, you would have received $100,000 upfront and started incurring interest expenses on the full $100,000 immediately. Upon receipt of payment from your customer, you would repay the loan in-full and the loan would be closed; if you had a future need, you would need to go through the loan process again.
| Line of Credit | Term Loan | |
| First Draw (1/1/2020) | $60,000 | $100,000 |
| Second Draw (3/1/2020) | $40,000 | $0 |
| Payment From Customer (06/01/2020) | $150,000 | $150,000 |
| Gross Profit | $50,000 | $50,000 |
| Interest Rate | 4% | 5% |
| Loan Origination Costs (2% of Loan Amount) | $2,000 | $2,000 |
| Interest Expense on First Draw | $1,000 | $2,083 |
| Interest Expense on Second Draw | $400 | $0 |
| Total Interest Expense | $1,400 | $2,083 |
| Total Cost of Loan | $3,400 | $4,083 |
| Net Profit | $46,600 | $45,917 |
It is important to note that the total interest expense for a term loan is nearly 50% higher than the interest expense when using a line of credit.
