A simple rule covers most cases. Use a term loan for things your business will own and use for years, such as equipment, a vehicle, a fit-out or an acquisition. Use a line of credit for gaps that open and close, such as waiting for customers to pay, buying seasonal stock or covering a slow month.
Lenders think about it the same way. They try to match how long the money is borrowed for with how long the thing it pays for lasts. If you ask for the wrong product, it is one of the quickest ways to get a weaker offer, or a decline.
The difference at a glance
| Term loan | Line of credit | |
|---|---|---|
| How you receive it | One lump sum up front | A limit you draw from and repay as you need |
| Repayment | Fixed instalments over 1 to 10 years | Interest on what you have drawn; the limit is usually reviewed every year |
| Interest | On the whole balance, falling as you repay | Only on the amount drawn, plus a fee on the limit |
| Best for | Assets, expansion, refinancing | Working capital, seasonal swings, timing gaps |
| Typical security | The asset being bought, often with other security | Receivables and stock, often with a personal guarantee |
| Main risk | Fixed payments even in a bad month | The bank can reduce or cancel the line at review |
What each one really costs
Term loan example. Borrowing $100,000 over 5 years at 10% interest means a monthly payment of about $2,125. Over the full term you pay about $27,500 in interest. You pay this whether you need the cash in your account or not, because you received all of it on day one.
Line of credit example. Take a $100,000 limit at 11%, where you use $40,000 on average across the year. The interest is about $4,400 a year. Many lenders also charge a commitment fee on the unused part. At 0.5% on the $60,000 you haven’t drawn, that adds $300. The rate is higher, but you only pay for money you are actually using.
Try your own numbers in our business loan calculator, or compare two offers side by side with the loan comparison calculator.
When a term loan makes sense
- You are buying something with a long useful life, such as machinery, a delivery van, premises or an IT system.
- You want to know exactly what you will pay each month for budgeting.
- You are refinancing expensive short-term debt into something more manageable.
- You have a clear plan that shows how the investment pays back over time.
The lender will look closely at whether your regular cash flow can cover the instalments. We explain how they test that in our guide to the debt service coverage ratio (DSCR).
When a line of credit makes sense
- Your customers take 30 to 90 days to pay, but your suppliers and staff need paying now.
- Your sales are seasonal, for example retail before the holidays, agriculture around harvest or tourism in summer.
- You want a safety buffer for the unexpected without paying interest on cash you don’t use.
Lenders usually size a line from your working capital cycle, using your receivables, stock and payables, not from your profit. Our line of credit basics guide covers how the limit is set and reviewed.
The mismatch mistake
The most common problem we see is a business using a line of credit to pay for long-term assets. The line never comes back down, because the cash went into a machine and not into stock that turns back into cash. At the annual review the bank sees a line that has been fully drawn for twelve months, which is called a “hard-core” balance. It may then insist the balance is moved into a term loan, often on worse terms.
The opposite mistake also costs money. If you take a large term loan to cover a short seasonal gap, you pay interest for years on cash you only needed for a few months.
Can you have both?
Yes, and many healthy small businesses do. A typical setup has a term loan for the fixed assets and a smaller line of credit for day-to-day working capital. Lenders often prefer it because each facility does its own job, and repayment is easier to track.
The covenants nobody mentions upfront
Most lines come with covenants. These are promises you keep for as long as the line is open, not just on the day you sign. The usual ones:
- A minimum DSCR. Checked every quarter or year, not just at the start.
- A borrowing base. On asset-backed lines, how much you can draw depends on your receivables and stock. If they shrink, so does your limit.
- A clean-up period. Some banks want the balance at zero for a set number of days each year. It proves the line is funding short-term needs, not quietly turning into long-term debt.
- Reporting. Monthly or quarterly accounts, on time. It sounds minor. In practice, late reporting is one of the most common reasons a relationship manager has to raise a file internally.
If your line never hits zero in a whole year, the bank will notice. At renewal they may ask to turn part of it into a term loan.
How a borrowing base works
On an asset-backed line, the bank won’t lend against the full value of your receivables and stock. It lends a percentage of each. For example, a share of invoices under 90 days old and a smaller share of finished stock. Add those up and you get your borrowing base. It moves every month with your balance sheet.
The catch is that in a slow month, when receivables drop, your available credit drops too. Right when you might need it most. Ask for the advance rates and eligibility rules in writing before you sign, and plan around them.
What to prepare before you ask
- A clear explanation of what the line will fund. Stock cycles, slow-paying customers, seasonal payroll. “General working capital” won’t cut it.
- Your DSCR worked out in advance, including the cost of the new line even if you don’t plan to use all of it.
- An honest answer to one question: will the balance hit zero at some point in a normal year? If not, say so and ask whether part of it should be a term loan.
- A reporting routine you can stick to. Covenants missed because of late paperwork cause more trouble than you’d think.
None of this makes a line of credit a bad idea. For the problem it’s built for, it’s usually the right tool. Just go in knowing the rules. You’ll be in a much stronger position than most people who walk in and ask.
Questions to ask your lender
- Is the rate fixed or floating, and what benchmark is a floating rate linked to?
- What fees apply: arrangement, commitment, renewal or early repayment?
- How often is the line of credit reviewed, and what could lead to it being reduced?
- What security and guarantees are needed, and can they be released later?
- What covenants will apply, and how often do you have to report?
Run your own numbers: use our free business loan repayment calculator to check your figures before you speak to your bank.
From the credit desk
What we look for when this comes up in a real credit file:
- The most common structuring mistake we see is using a short-term running finance line to pay for long-term assets. When the line is reviewed, the business cannot repay it.
- A running finance limit is reviewed every year. Keep your account active, submit stock and debtor statements on time and avoid staying at the full limit for months.
- For Islamic banks the equivalents are Running Musharakah for working capital and Diminishing Musharakah or Ijarah for long-term assets.
Frequently asked questions
Is a line of credit easier to get than a term loan?
Not really. Because the bank is committing to keep cash available, lines often come with more covenants and closer monitoring.
Do I pay interest on the whole limit?
Usually only on what you’ve drawn. Many banks also charge an arrangement fee or a small fee on the unused part, so read the fee schedule.
What happens if I break a covenant?
It depends on your agreement. Often it starts with a conversation, a waiver or changed terms. But a breach can also let the bank cut the limit, raise the price or, in serious cases, ask for repayment. Telling your banker early nearly always helps.
How often is a line renewed?
Most are reviewed once a year. The bank looks at your latest accounts, whether you’ve kept to the covenants, and how you’ve actually used the line.
Sources and further reading
- State Bank of Pakistan: Laws and Regulations (Prudential Regulations)
- State Bank of Pakistan: Islamic Banking Department
This article is general information, not financial advice. Product terms differ by lender and country, so check the details with your bank or adviser before you borrow.
Related: the SME Loan Package Starter Kit calculates DSCR, ratios and repayment schedules in one Excel file.
Related guides
- The Working Capital Cycle, Explained: How Much Cash Your Business Really Ties Up
- Fixed vs Floating Interest Rates on Business Loans
- Loan Covenants Explained: The Promises You Make After the Loan Is Approved
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