Definitive Guide to Working Capital vs. Term Loans for Small Businesses
August 22, 2023 | Last Updated on: September 03, 2024
Whether you’re just starting out or you’re trying to grow your business by taking advantage of a market opportunity, there are many business financing options available.
Small business loans can help entrepreneurs navigate challenges and invest in business expansion. But with many loan types available, it can feel overwhelming to determine what’s right for your business.
There are benefits to both short-term and long-term business loans, as well as drawbacks. The right loan for your business really depends on your unique situation. More common short-term business loans include working capital loans, while long-term loans tend to be term loans.
Each may be right for your business, but our business loan comparison will help you assess working capital vs. term loans before making a decision.
In this article:
- Learn the basics of small business lending, including different types of working capital loans and term loans.
- Explore the pros and cons of working capital loans.
- Explore the pros and cons of term loans.
The basics of small business lending
Small businesses have access to a wide variety of financing options. Traditional banks, credit unions, and online lenders offer many loan products designed for different business purposes.
Provided a small business owner has a strong personal credit score and the business has a proven financial track record, it should be possible to get approved for a loan with favorable terms.
(Even entrepreneurs with poor credit can still access bad credit business loans, although they may have to pay higher interest rates or put up more collateral.)
Small business lending and the overall loan process have evolved with the advent of automation and stronger digital lending tools.
Ultimately, the process has become 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.
Difference Between Working Capital Loans and Term Loans
A business loan comparison should always be the first step when you’re considering applying for financing. When it comes to working capital loans vs. term loans, there are a number of key differences. These include:
- Usage: Working capital loans are typically used to fund day-to-day business operations, and may have either revolving or non-revolving funds available. Term loans are lump sum payments that businesses typically use to finance long-term investments, like business acquisitions or growth activities like hiring.
- Repayment periods: Working capital loans tend to have shorter repayment periods, sometimes with terms as short as daily payments. Term loans tend to have repayment periods of several years.
- Interest rates: Since they have faster repayment windows, working capital loans often have higher interest rates than term loans.
- Collateral: Working capital loans are typically unsecured, while term loans often require collateral to secure the loan against default.
There may be many more small differences between working capital loans vs. term loans depending on your lender and business loan type, but these are the core factors to note. Basically, working capital loans are designed to increase cash flow and finance short-term and day-to-day business needs, while term loans are typically used with a longer term in mind.
Types of Working Capital Loans & Financing
Working capital loans describe any type of small business loan that provides smaller amounts of capital quickly. There are several types of working capital loans and there are other financing options that are not loans but help business owners secure working capital they need to run their operations day to day.
Let’s start with two options that are not loans, but which can be useful for business owners that need working capital in their business:
Working Capital Loan
A working capital loan is a type of loan that provides a short-term cash infusion for a business that needs a financing solution for their day to day operations and current liabilities such as recurring payments or large invoices.
These loans are often provided through a service provider that is familiar with a business’s operations and knows what is required to make a full repayment of the loan.
For example, many online payments companies will offer working capital loans to their clients because they can see all of the payments that these businesses are receiving and will have confidence to provide capital on the strength of that revenue history.
SBA CAPLines and Working Capital 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.
The CAPLines program offers several types working capital lines of credit for small businesses:
- Seasonal CAPLine
- Contract CAPLine
- Builders CAPLine
- Working CAPLine
The SBA also began processing working capital loans through the 7(a) loan program in August 2024, providing small businesses with another short-term business loan option. This program is still in its early stages, so check back in the future for more details about how it works and how you may be able to qualify.
Invoice Financing / Factoring
Invoice financing, sometimes called 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.
For instance, if a creative agency has an urgent need to purchase new computers for its staff members, it could get a quick influx of money through invoice factoring to purchase the computers and increase productivity.
Merchant Cash Advance
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. To be clear, much like invoice factoring a merchant cash advance is not a loan.
The borrower repays the advance with weekly or monthly payments based on an agreed-upon percentage of sales. If sales go up, the payment will come in a little bit higher.
If sales go down, the payment can come in a little bit lower, proportionally. Essentially, it’s trading future revenues for the benefit of having more cash now.
Business Line of Credit
A business line of credit is a type of revolving credit that is something of a cross between a business credit card and a business loan. compared to taking out a business credit card. Interest is charged only on the amount of credit the small business has withdrawn.
Lines of credit are a great way for new business owners to increase cash flow while building credit history which can open more business 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 require a low minimum credit score for approval. Borrowers can check their creditworthiness 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 and financial profile secures the funds. First-time borrowers or those with bad credit can secure lower interest rates by choosing a secured term loan.
Term loans may be offered by banks, credit unions, and online lenders, many of which offer SBA term loans, like the popular 7(a) term loan program. Term loans vary in their conditions between lenders, most often:
- Interest rates
- Repayment periods
- Collateral requirements
Pros and Cons of Term Loans
Like any business loan type, term loans have advantages and disadvantages. Some of the primary term loan benefits include:
- Flexibility: A term loan can provide the capital necessary to cover unexpected operating costs, while not impacting the amount of funds available for operating expenses, like payroll, utility bills, and lease obligations.
- Improving 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.
- Large maximums and long repayment periods: Term loans often have higher maximum loan amounts, making them better options for major business growth initiatives that you expect will take several years to see through.
It’s not all positive, however. Term loans carry more risk than working capital loans, as they’re often for higher amounts and keep your business in debt longer.
Defaulting on a term loan or falling short on monthly payments can have a significant impact on both the business’s credit and the owner’s personal credit score. Likewise, it’s debt that you’ll have to account for and make payments on every month, even if you’ve already spent the funds.
Are Working Capital Loans or Term Loans Better?
The question isn’t so much which of working capital vs. term loans is better, but which is better for your business. Every small business is at a different stage, in a different industry, and has different goals. What’s better for one business may not necessarily be better for another.
Working capital loans tend to be better for small businesses with short-term goals, and that plan to use the money to increase cash flow and cover day-to-day operating expenses and support everyday business activities and current assets.
Term loans tend to be better for small businesses ready to invest in long-term growth that need a large amount of money to acquire business assets, launch new products, or hire more people. Businesses that need the flexibility to pump money into the business now and pay it back over several years will find term loans are better suited to their needs.
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.
Conclusion
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 financing, like invoice factoring and merchant cash advances, may 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. Either option may be a quality business funding solution for your small business.
To discover which type of business financing is right, is to explore the lending options available at Biz2Credit.
FAQs
What are working capital loans vs. term loans?
Working capital loans are short-term loans that help a business increase cash flow and day-to-day operational expenses. They tend to have short repayment terms and lower eligibility requirements than term loans, which are lump sum payments upfront with longer repayment schedules designed to help small businesses invest in expansion and growth.
Are working capital loans or term loans better?
Understanding if working capital vs. term loans would be better comes down to your business’s unique needs. If you just need help navigating cash flow gaps like a seasonal lull in business or support day-to-day operations, a working capital loan is a more flexible option to pump some liquidity into the business and cover working capital needs without taking on significant debt. If your business has more than simply operational needs, like a desire to acquire real estate or grow aggressively, the longer repayment periods and higher maximums of a term loan will be better for your business.
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