BUSINESS FUNDING

Business Line of Credit vs Term Loan: The Real Cost

By Baruch Mackliff, the Capital Commander · PRBE Capital

Topic: Business funding and what it costs you

Two products get compared as though the only difference between them were the interest rate. A term loan and a revolving line of credit are built to fund different things, priced on different mechanics, and reviewed on different schedules. The rate is the part of that comparison that matters least.

One sentence is worth carrying into every version of this conversation: a term loan funds something that will still exist in three years, and a line of credit funds a gap that closes by itself. Borrowing on the wrong side of that sentence does not hurt in the first month. It hurts at renewal, which is usually eleven months later and at the worst possible time.

What a term loan is built to fund

A term loan advances a fixed amount once, on one day, and sets a schedule that retires it. You receive the principal at closing and begin repaying on an amortisation schedule, which means every payment contains interest on the outstanding balance plus a slice of principal.

Three consequences follow from that structure.

The balance moves in one direction only. Once the loan funds, the money is committed and the obligation is fixed. Paying it down does not create room to borrow it back. If you need the money again next quarter, that is a new application.

Interest runs on the full amount from day one. From the moment of funding you are paying on the entire balance whether or not the cash has left your account yet. Money that sits in your operating account waiting for a supplier is still costing you.

The maturity is matched to what the money bought. A lender sets the term against the working life of the purchase: property supports a long schedule, a machine follows its useful life, and a general-purpose loan for operating needs is shorter than either. A term loan is also, ordinarily, not callable. Absent a default or a covenant breach, the lender cannot demand it back early. That stability is a large part of what you are actually buying.

What a line of credit is built to fund

A revolving line is a commitment, not an advance. The lender agrees to a ceiling. You draw against it when you need cash, repay when the cash comes back, and draw again. Interest accrues only on what is outstanding, usually calculated on the daily balance rather than on the size of the commitment.

The structural features that decide how it behaves:

• It is reviewed on a clock. Most operating lines mature within a year and are renewed after a fresh look at your statements. Renewal is a decision, not an entitlement. A line can be renewed at a lower ceiling, renewed with new conditions attached, or not renewed at all, and none of that requires you to have done anything wrong.
• Availability is not the same as the commitment. On a secured operating line, what you may actually draw is governed by a borrowing base: an advance rate applied to eligible receivables and, sometimes, eligible inventory. Receivables past a stated age, balances from affiliated companies and concentrations in a single customer are commonly excluded. The ceiling is the maximum. The borrowing base is the number you can reach today, and it moves every month.
• The rate usually floats. A line is typically quoted as an index plus a margin, which means the payment changes when the index changes. Read the index name, the margin, any floor and the reset frequency in your own offer.
• There may be a clean-up requirement. Some lines carry a covenant requiring the balance to rest at zero for a set number of consecutive days each year. That clause exists to prove the line is funding a cycle rather than covering a permanent shortfall.
• Payments are often interest-only. A monthly interest payment on a drawn balance looks small next to an amortising term payment. It also never retires principal. The comparison is not like for like.

The cost difference nobody sets up correctly

Most owners compare the two quoted rates and take the lower one. That comparison is close to meaningless, for three reasons.

• The rates apply to different amounts. A term loan rate applies to a declining balance on a fixed schedule you can print. A line rate applies to whatever you happen to owe on each day of the year, which is a forecast, not a schedule.
• Undrawn money is not free. Most committed lines carry a fee on the portion you are not using, variously called an unused line fee, a non-use fee or a facility fee. A line you never touch still bills you. That is the price of the lender reserving the capacity.
• The fixed costs recur on different cycles. A term loan's origination fee, filing costs, appraisal and legal review are paid once. A line's renewal fee, and in an asset-based structure its collateral field examination, come due again every year for as long as the facility exists.

Build the comparison in dollars instead of percentages. Write down, month by month for the coming year, the balance you expect to owe. For the term loan that is simply the amortisation schedule the lender will give you. For the line it is your own honest forecast of draws and repayments. Apply each quote's pricing to each month's balance, add every fixed and recurring fee, and add the unused-line fee on the undrawn portion. You end up with two totals you can actually compare, and the answer is frequently not the one the lower headline rate predicted.

Every rate, fee and index in this discussion changes over time and differs by lender and by facility. Do not carry a figure you read anywhere into your own file. Confirm the current numbers in your own written offer, and ask for the total of payments in writing.

What a line costs when you use it like a term loan

This is the expensive mistake, and it is common enough to have a name at the bank: the line goes evergreen.

It happens when a revolving facility is drawn to pay for something permanent. A build-out, a deposit on a property, a vehicle, a hire whose salary the business cannot yet carry. The draw funds it. Then the balance never comes down, because nothing in the business converts that spending back into cash on a cycle.

The lender sees the pattern immediately. A line that never rests is not funding a working capital swing, it is funding a structural gap, and the lender's file starts describing it that way. At renewal you are offered a term-out: the outstanding balance is converted into an amortising term loan, on the lender's terms, at the exact moment you have no leverage and no operating line. Businesses that were fine the month before find themselves with a new fixed payment and nothing left to draw on.

The inverse mistake is quieter and cheaper but still real. Taking a term loan for a seasonal purchase means paying interest on the full balance through the months you did not need the money.

The mechanics that sit outside the rate

• Collateral shape. A term loan for a specific purchase is often secured by that purchase. An operating line is usually secured by a blanket lien over receivables, inventory and general business assets. The blanket lien is the part owners miss: once it is filed, it sits ahead of anyone you want to borrow from next.
• Reporting load. A term loan may need annual statements. A borrowing-base line commonly needs a monthly certificate, a receivables ageing, a payables ageing and sometimes an inventory listing, each on a deadline. Late reporting is a technical default in a lot of loan agreements.
• Covenants. Both can carry them. Coverage and leverage tests are the common ones, measured on a defined formula stated in the agreement. Ask which statements the test is computed from and on what frequency, because a test computed on interim figures behaves very differently from one computed annually.
• Exit cost. Term loans can carry prepayment charges, sometimes a declining schedule over the early years. Lines usually have no prepayment penalty on a draw but can carry an early termination fee if you close the facility before maturity.
• Guarantees. Both commonly require personal guarantees from owners above a stated ownership percentage. The guarantee usually survives the facility, so read what releases it.

Which one your situation actually points to

Write down what the money is for, and then ask a single question about it: does this spending turn back into cash on its own, and roughly when?

If the answer is a date within the operating cycle, you are describing a line of credit. Inventory bought for a season and sold by the end of it. Payroll on a contract that invoices on completion. A receivable that will be collected in sixty days. The spending creates the cash that repays the draw, which is exactly the behaviour a revolving facility is designed around.

If the answer is that the spending becomes an asset, a capability or a permanent increase in the size of the business, you are describing a term loan. The repayment has to come out of earnings over years, and a facility that can be reduced at renewal is the wrong container for it.

If the answer is that you are covering losses, neither product is the answer, and a lender who has read your statements already knows it. The conversation you need is about the operating problem, not the facility.

Many businesses end up holding both, and that is the healthy outcome rather than a sign of over-borrowing: a term loan carrying the permanent assets, and a line breathing in and out with the cycle. What a lender wants to see is each one doing its own job.

What to ask for before you sign either one

Ask for the amortisation schedule on the term loan and read the final payment. Ask whether the rate is fixed for the full term or resets, and on what index. On the line, ask for the borrowing base formula in writing, including every category the lender treats as ineligible, the advance rates, the renewal date, the unused line fee and whether a clean-up requirement applies. Ask both lenders for the total of all fees payable at closing and annually thereafter.

Send the same one-page description of your need to every lender you speak with, so the proposals that come back are comparable. Lenders answer the question you ask them; different questions produce quotes that cannot be lined up beside each other.

PRBE Capital works with owners at exactly that point: separating what is a cycle from what is permanent, sizing the facility against the real pattern of cash in the business, and getting a comparable set of written proposals in front of you before anyone commits to a deadline. The first conversation costs nothing and promises no approval.

This is an explanation of how these two products are structured, not legal or financial advice. Rates, fees, advance rates and covenant terms vary by lender and change over time, so confirm the current terms in your own written offer and with your own advisers before signing.

Common questions

What is the difference between a business line of credit and a term loan?

A term loan advances a fixed amount once and retires it on a set amortisation schedule, and paying it down does not let you borrow it back. A line of credit is a revolving commitment you draw against, repay and draw again, with interest accruing only on the outstanding balance. The term loan is built for permanent spending, the line for a gap that closes within your operating cycle.

Is a business line of credit cheaper than a term loan?

Not reliably, and the quoted rates do not settle it. A line charges on the daily balance but usually adds a fee on the undrawn portion and a renewal cost every year, while a term loan charges on the full balance from day one but pays its fixed costs once. Compare total dollars across a realistic month-by-month forecast rather than comparing two percentages.

Do you pay anything on a business line of credit if you never use it?

Usually yes. Most committed lines carry an unused line fee, non-use fee or facility fee charged on the portion you are not drawing, because the lender is reserving that capacity for you. There may also be an annual renewal cost. Ask for the fee schedule in writing before you accept the commitment.

What is a clean-up period on a line of credit?

It is a covenant requiring the drawn balance to rest at zero for a stated number of consecutive days each year. The clause exists to demonstrate that the line is funding a working capital cycle rather than covering a permanent shortfall. If your facility has one, it is in the loan agreement, and missing it is a covenant breach.

Can a bank reduce or cancel my business line of credit?

Most operating lines mature within a year and are renewed only after a fresh review, so the lender can renew at a lower ceiling, add conditions, or decline to renew. A secured line is also limited by its borrowing base, which can shrink between reviews when receivables age or concentrate. A term loan, by contrast, generally cannot be called absent a default or covenant breach.

Should I use a line of credit to buy equipment or fund a build-out?

It is the most common and most expensive misuse of a revolver. Permanent spending never converts back into cash on a cycle, so the balance stops resting and the lender begins treating the facility as a structural gap. The usual result at renewal is a term-out of the balance on the lender's terms, with no operating line left underneath you.

What is a borrowing base on a business line of credit?

It is the formula that decides how much of your commitment you may actually draw today: an advance rate applied to eligible receivables and sometimes eligible inventory. Receivables past a stated age, affiliate balances and heavy concentration in one customer are commonly excluded. Ask for the full eligibility definition in writing, because the ceiling on the commitment letter is not the number you can reach.