Working capital loan or term loan: how to choose

Most small businesses borrow for one of two reasons: to cover a short gap between paying out and getting paid, or to pay for something that will earn money for years. Those needs fit different products, and using the wrong one is one of the most common ways small businesses overpay for credit.

What each one is

A working capital loan is short-term financing for day-to-day costs such as payroll, inventory or a seasonal dip. Terms are usually measured in months, payments are often taken weekly or even every business day, and the cost is sometimes quoted as a factor rate rather than an APR.

A term loan is a lump sum repaid over a fixed period, usually one to five years for online lenders and longer for banks and SBA loans, with monthly payments and an interest rate. It’s built for purchases and projects that pay off over time.

A worked example

These figures are an illustration, not offers. A shop needs $50,000 for holiday inventory it expects to sell within six months.

Option A is quicker to arrange and is done in six months, but the payments are heavy: about $9,333 a month on average, taken weekly. Option B costs less even though it runs longer, because interest is charged only on the balance still owed. If the inventory sells and the shop pays the loan off after six months with no prepayment fee, it pays about $3,384 in interest instead of $6,000.

Now suppose sales come in slower than planned. With Option A, the weekly payments keep coming whether the stock sells or not. With Option B, the monthly payment is lower and spread over two years, which leaves room to wait out a slow month. Matching the repayment period to how long the money is really needed is the main lesson.

The catch: the term loan may take longer to approve and may need stronger credit and financial statements. If the inventory has to be ordered this week, speed can be worth paying for, as long as you know what you’re paying. Try your own numbers in the factor rate to APR calculator or the payment calculator.

How lenders decide

Working capital lenders tend to focus on recent cash flow: they’ll often ask for three to six months of business bank statements and look at average balances, deposits and how often the account runs low. Term loan lenders usually want more: a longer time in business, tax returns, financial statements and a stronger credit score for the owner. That extra paperwork is a big part of why term loans take longer, and also why they tend to cost less.

When a working capital loan makes sense

• The gap is short and you know where the repayment money will come from.
• The payment schedule matches how money comes into the business. Daily payments suit a business with daily card sales; they’re hard on one paid by invoice every 30 days.
• You’ve compared the estimated APR, not just the factor rate or the monthly figure.

When a term loan makes sense

• You’re buying something that will earn money over several years.
• You want predictable monthly payments.
• You can wait a little longer for approval in exchange for a lower total cost.

Consider a line of credit too

If you have recurring short gaps rather than a single one, a business line of credit lets you draw what you need, repay it and draw again, paying interest only on what you’ve drawn.

Signs you’re using the wrong product

• You’re taking a new short-term loan to pay off the last one. That’s a sign the need is long-term and a term loan or line of credit would cost less.
• Daily or weekly payments regularly leave the account close to empty.
• You financed equipment or a renovation with short-term money and the payments are crowding out everything else.

Questions to ask before you sign

1. What’s the total I’ll repay, including every fee?
2. What’s the APR, or the estimated APR if you quote a factor rate?
3. How often are payments taken, and can I change the schedule if sales dip?
4. Does paying early reduce what I owe?
5. Is there a personal guarantee, and will you file a lien (a UCC filing) on business assets?