Definitive Guide to Working Capital vs. Term Loans for Small Businesses

In this article:

• The basics of small business lending
• Types of working capital loans
• Pros and cons of working capital loans
• Types of term loans
• Pros and cons of term loans

The basics of small business lending

Small business lending and the overall loan process has evolved since the pandemic. Automation and the digital transformation in the lending industry have made the process much easier for borrowers. Using digital lending platforms and real-time apps, borrowers can calculate loan payments and predict profitability before they even reach out to a lender.

In this article, we explore two of the most common financing tools for entrepreneurs: working capital loans and term loans.

Types of working capital loans

Working capital loans describe any type of small business loan that provides smaller amounts of capital quickly. Loans for the purpose of covering a large purchase or supplementing cash flow during periods of transition fall into the category of working capital loans.

Invoice factoring

Invoice factoring is an alternative financing option that lets small business owners receive cash immediately for unpaid invoices. An invoice factoring agent purchases the invoices, collects for them, and sends the balance to the business, less fees, which are calculated using a predetermined factor rate.

Merchant cash advances

A merchant cash advance (MCA) is a financing arrangement for any business that accepts debit or credit card payments through a point of sale (POS) system. The borrower repays the advance, or loan, with weekly or monthly payments based on an agreed-upon percentage of sales.

SBA loans

The U.S. Small Business Administration (SBA) provides working capital options, as well as term loans, with lower down payments and lower interest rates than traditional sources of funding because a portion of each loan is guaranteed by the SBA, a government agency.

Working capital line of credit

A business line of credit is a type of revolving credit that is often compared to taking out a business credit card. Interest is charged only on the amount of credit the small business has withdrawn. Working capital lines of credit are a great way for new business owners to build credit history which leads to more financing options in the future.

Pros and cons of working capital loans

There are several benefits to securing a working capital. The most common reasons entrepreneurs turn to working capital loans over traditional lending tools include the following:

• Timing – The process from application to funding is much faster with working capital loans than with traditional bank loans.
• Approval – The approval odds for small business owners applying for working capital loans are better than most long-term loans. Some financing arrangements do not require a credit check or have a low minimum credit score required for approval. Borrowers can check their credit using annualcreditreport.com.
• Convenience – Most working capital lenders offer online applications, underwriting processes, and fast funding. When Satinda Sharma, of Brick Lane Curry House, worked with Biz2Credit to secure a business line of credit, he was impressed with the easy-to-use, real-time, lending software and pleasant customer experience.

Disadvantages to working capital loans including shorter lifecycles and higher financing costs. While they are a great lending solution for business owners planning to fund a start-up or cover a large purchase, they often have higher interest rates than term loans.

Types of term loans

A term loan is a traditional type of business financing. Term loans can be secured, where collateral is required, or unsecured, where the borrower’s credit secures the funds. First-time borrowers or those with bad credit can secure lower interest rates by choosing a secured term loan.

• Short-term loan – Require that the debt be paid off in full or refinanced within 0-18 months.
• Medium-term loan – Options offer repayment periods of 1-5 years
• Long-term loan – Repayment terms of more than six years are considered long-term loans.

Pros and cons of term loans

An essential part of the decision-making process is to consider the advantages and disadvantages of borrowing funds. Loans impact the business’s credit history and monthly cashflows. Business owners should be confident that their decision to borrow funds will fit into the long-term business plan and help the owner meet monthly and annual benchmarks. Working with a lender and exploring different types of loans is the best way to understand the long-term effects of financing for your business.

Some of the pros of term loans include the following:

• Cashflow flexibility – A term loan can provide the capital necessary to cover unprecedented costs, while not impacting the amount of funds available for operating expenses, like payroll, utility bills, and lease obligations.
• Build better business credit – Taking out a term loan helps new business owners build good business credit. Business credit scores are reported by three major credit bureaus including Experian, Dun and Bradstreet, and Equifax.
• Income tax savings – The interest portion of a term loan payment qualifies as a business tax deduction for most business owners, so they can decrease the overall tax liability and may even result in an income tax refund for the business.

While the pros often outweigh the cons of a term loan, disadvantages to consider before borrowing include:

• Impact on business credit – Defaulting on a loan or taking on more monthly payments then current revenues support can negatively impact credit.
• Decreased monthly cashflow – Term loans require a monthly payment of principal and interest.

Takeaways

Working capital loans and term loans are both great solutions for business owners looking to get started, expand, or navigate periods of inconsistent cashflows. Working capital loans, like invoice factoring and merchant cash advances, tend to be better for entrepreneurs that are just starting out or have had some negative business credit activity and are seeking a short-term solution. Term loans offer a longer-term, more affordable option for established business owners. The best way to discover which type of business financing is right, is to explore the lending options available at Biz2Credit.