Line of Credit vs Term Loan: Funding an Investment Opportunity

When an investment opportunity turns up (a share parcel, a business expansion, a chance to add equipment ahead of a big contract) how you fund it matters almost as much as the opportunity itself. Two common paths: a line of credit, or a term loan.

The choice is not really about which one is cheaper on the rate sheet. It is about whether you are funding a known amount once, or an unknown amount repeatedly. Pick the wrong shape and you either pay for access you never use, or you end up back in an application every time the business needs money. Both mistakes cost, and the second one costs time as well.

Term loan

A term loan is the familiar structure. You borrow a fixed amount, repay it over a set period at a fixed or variable rate, and once it's paid off, that's it.

The mechanics are worth spelling out. The full amount is advanced at settlement, and from then on you are repaying principal and interest on a schedule until the balance reaches zero. Early in the term more of each payment is interest. Later more of it is principal. You generally cannot put money back in and take it out again, so once a term loan is drawn, that money has left the facility for good.

Best suited to:

• A one-off, defined investment where you know the exact amount needed upfront
• Situations where you want a clear end date and predictable repayments
• Larger amounts where a lower, secured rate matters more than flexibility
• Assets or projects with a working life long enough to justify paying for them over years rather than months

Secured or unsecured?

Term loans come both ways and the difference is large. A secured loan is backed by an asset the lender can take if you default, commonly property or the equipment being bought. That security usually buys a better rate and a longer term, because the lender's downside is covered. An unsecured loan is assessed on the business itself, which generally means a shorter term and a higher cost, and often a personal guarantee from the directors on top.

What is a break cost?

If your loan is on a fixed rate and you pay it out early, the lender may charge a break cost. It exists because a fixed rate is a commitment on both sides, and the lender has priced the deal on the assumption the loan runs its term. The amount is not a flat fee. It is calculated by the lender and can vary with how much is left to run and what has happened to rates since. Ask how it is worked out before you sign, not when you are trying to exit.

Line of credit

A line of credit gives you access to a set limit that you can draw down, repay, and redraw as needed. Closer to a very large credit card than a traditional loan. You typically only pay interest on what you've actually drawn, not the full limit.

The limit is agreed once and then it sits there. Draw on it, and the balance behaves like a loan. Put money back in, and the room becomes available again without a new application. Most facilities are reviewed periodically, which means the lender looks at the business again and can adjust or withdraw the limit at review. That review is the part people forget, and it is why a line of credit is not the same as money in the bank.

Best suited to:

• Ongoing or unpredictable funding needs, where the exact amount and timing aren't fixed
• Businesses that want a buffer available for opportunities as they arise, without reapplying each time
• Situations where cash flow moves in and out and having redraw flexibility matters more than the lowest possible rate
• Seasonal trading, where money goes out for stock or wages well before it comes back in

What does a line of credit cost when you are not using it?

Usually something. Many facilities carry a line fee or facility fee charged on the approved limit rather than the drawn balance, so the full limit costs you whether or not the money is out. There can also be an establishment fee, and on a secured facility, valuation and legal costs. Size the limit to what you realistically need rather than the largest number you can get approved, because the unused part is not free.

The trade-offs

A term loan usually comes with a lower rate and more certainty, but less flexibility once you've drawn the funds. You can't easily access more without a new application. A line of credit gives you ongoing flexibility, but often at a higher rate, and the temptation to keep drawing on it can turn a short-term tool into long-term debt if it's not managed carefully.

There is a discipline point underneath that. A term loan forces the debt down, because the schedule does the work whether you think about it or not. A line of credit only comes down if you put money back in. Businesses that use one well treat it as a facility that should sit near zero most of the year and spike when it is needed. Businesses that use one badly end up with a balance that never falls below a certain level, which is a term loan with none of the structure and a higher price.

Putting some numbers on it

An example, using round figures that are illustrative only and not an offer or a quote.

Say you need $200,000 for a defined expansion, spent once, on gear that will still be earning in six years. A term loan advances the $200,000, and you repay principal and interest until it is gone. You know the end date on day one.

Now say instead your need is lumpy. Across a year you might be out $40,000 in a quiet month and $150,000 in the month you fund a big job, and by the end of the year you have cleared it. A $200,000 line of credit charges interest only on what is drawn at the time, so in the quiet month you carry interest on $40,000, not on $200,000. Against that, the line fee is generally charged on the whole $200,000 the entire time. The right question is whether the flexibility is worth that fee plus the higher rate, and that depends on how often you actually draw.

Questions worth asking yourself first

These are the ones that sort the decision quickly, before anyone quotes anything.

• Do I know the exact amount I need, or is this an ongoing need?
• Am I comfortable with a fixed repayment schedule, or do I need flexibility to repay and redraw?
• Is this a one-off opportunity, or the start of a recurring need for accessible capital?

One more worth adding. How long will the thing I am funding last? Funding a five year asset with a facility that gets reviewed every year introduces a risk that has nothing to do with the asset. Funding a short cash flow gap with a five year loan leaves you paying for it long after the gap closed.

What lenders look at either way

Business lending is assessed on the business, not just on you. The questions are much the same for both structures, though a revolving facility tends to attract closer attention to how the account is actually run.

• ABN and GST registration, and how long each has been held
• Time in business, and whether the entity is a sole trader, company or trust
• Recent BAS lodgements and business bank statements, usually several months of them
• Financial statements and tax returns for a full documentation application
• Existing commitments, including other facilities, equipment finance and any guarantees already given
• The credit file of the directors or the sole trader behind the business, including recent enquiries
• What security is on offer, and whether a director is prepared to give a personal guarantee
• For a line of credit, how the trading account behaves: dishonours, overdrawn days and how the balance moves

Do multiple applications hurt?

Each formal application generally leaves an enquiry on the credit file, and a cluster of enquiries in a short window can read badly to the next assessor because it looks like you have been declined repeatedly. That is an argument for working out which structure you want before you start lodging, rather than applying widely and seeing what sticks.

Other structures sitting near these two

A business overdraft is close to a line of credit but attached to your trading account, so the facility absorbs the day to day rather than sitting separately. Invoice finance advances money against unpaid invoices, which suits a business whose problem is timing rather than capacity. Equipment finance funds a specific asset with the asset as security, which is usually cheaper than putting the same purchase on a general facility. A business credit card is fine for small, frequent expenses and expensive for anything that stays outstanding.

Matching the tool to the job is most of the skill here. Long life assets belong on structured, secured, longer term finance. Short, repeating gaps belong on something revolving. Mixing the two up is the most common expensive mistake in business borrowing.

What to have ready

Whichever way you lean, the same paperwork gets asked for, and having it together shortens the process considerably.

• ABN, entity details, and GST registration status
• Your most recent BAS lodgements
• Business bank statements covering recent months
• Financials and tax returns if you are going full documentation
• A written summary of what the money is for and how it will be repaid
• Details of any security you can offer, including current loan balances against it
• Director identification and a list of existing personal and business commitments
• A realistic cash flow view for the next twelve months, particularly if you are asking for a revolving facility

Where to land

Neither structure is inherently better. They solve different problems. Compare City can run both options against your specific numbers so you can see which one actually costs less for what you're trying to do.

If the amount is known and the purpose is a single defined investment, the term loan is usually the honest answer. If the need keeps coming back and the timing is unpredictable, the flexibility of a line of credit may well be worth what it costs. Plenty of businesses end up with both, each doing the job it is suited to, which is a perfectly sensible outcome rather than a sign of indecision.

More on a business line of credit, business term loans and business loans.