Sometimes borrowers use the words “loan” and “line of credit” interchangeably, but these are in fact two different lending products. I’d like to call attention to some important differences between these two products.
When a $50,000 loan is issued to a borrower, the lender expects the entire amount, plus interest, to be paid back in X number of years. When an applicant walks away from the bank after being approved for a loan, they usually have a check for the whole $50,000. Each month that a payment is made, the loan balance decreases. Once the balance hits zero, nothing more is owed to the bank and consequently the bank has no additional obligation to reissue another loan to the borrower. The loan has been retired.
When a $50,000 line of credit (LOC) is issued to a borrower, the lender doesn’t expect the entire amount to be paid back at a certain time in the future. (This is usually the case – there are exceptions.) When a successful LOC applicant walks away from the bank, they typically don’t have a check in hand for the full amount; they usually have a checkbook or a credit card with a zero balance. The borrower doesn’t have to make payments on the LOC until they actually spend the money. If they spend the full $50,000 (or some lesser amount) to purchase some advertising for their business, they are then obligated to start making payments to the lender, according to the LOC Terms.
The most important distinction between a loan and a LOC is if the borrower pays the balance down to zero on a LOC then they can spend the money again. If the borrower pays off a LOC a second time, they can continue to “dip in” as needed. It’s a cycle that could last for years as long as a good relationship with the lender is maintained. This is not the case with a loan.
There is a time and place where both loans and lines of credit should be used in your business. If you need money for certain project or for a set period of time, you might want to consider a loan. Interest rates are typically more favorable with a loan. If you want some emergency money “just in case,” I’d definitely recommend a LOC. This way you don’t have to make monthly payments unless you use it; you don’t want to pay interest on money that isn’t being used. The key is having access to capital, not necessarily having it in the bank.
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Garrett Sutton, Esq., author of Start Your own Corporation, Run Your Own Corporation, Loopholes of Real Estate, The ABC’s of Getting Out of Debt, Writing Winning Business Plans and Buying and Selling a Business in the Rich Dad Advisors series, is an attorney with over twenty-five years experience in assisting individuals and businesses to determine their appropriate corporate structure, limit their liability, protect their assets and advance their financial, personal and credit success goals.
Gerri Detweiler is the author of four books, including the Ultimate Credit Handbook (named one of the top five personal finance books of the year when it was released), and a media favorite quoted in publications like USA Today, The Wall Street Journal and featured on The Today Show and CNN. A credit educator since 1987, she’s served on credit reporting agency Experian’s Consumer Advisory Council twice.