Businesses and loans are almost inseparable. Almost every business requires a loan, be it for expansion or to run operations smoothly. Different options are available for companies that serve different purposes. A business must smartly choose loans to ensure that its needs are met most efficiently. Two of the most popular loan options available to companies are working capital loans and term loans. To choose one of two that meets the requirement, one must understand the differences between the working capital loan vs. term loan.
Before we discuss the differences between the working capital loan vs. term loan, we first need to get an idea about each of these loan options.
Working Capital and Term Loan – What are They?
Working capital loans are usually treated as short-term loans and typically have an annual review. Here the repayment period could vary between three months to twelve months or less. The amount of working capital loans depends on the cost of running the business. It also depends on the quantum of inventory and debtors usually maintained by the company. A business can take this loan as many times it wants, provided it makes timely repayment or sufficient stocks, and debtors level is maintained.
Term loans, on the other hand, are long-term loans with a repayment period of one to ten years. These loans are primarily for expansion, buying a new asset, etc. Term loans are usually secured and for capital items.
Working Capital vs. Term Loan – Differences
Following are the differences between Working Capital vs. Term Loan:
Working capital loans are short-term with a repayment period of a few months. Term loans, on the other hand, can be short, medium, or long term. Their duration is usually between one to ten years, but some term loans could extend up to 30 years.
Businesses usually take a working capital loan to meet the shortfall in working capital or to finance routine business operations. For example, paying rent, the salary of the staff, vendor, and more or the. Term loans, on the other hand, allow the business to go for expansion, buy a new plant, machinery, or any other capital asset.
Since term loan is a long-term loan, its repayment is in many installments. On the other hand, there are limited installments for the repayment of working capital loan as the amount is small.
Working capital loans are easy to get, especially if a business has a good credit standing. Also, it does not involve a lot of paperwork, as it is a short-term loan. The term loan consists of a lot of paperwork and procedures. The lenders need to carry a thorough check before approving or rejecting a loan request, such as borrowers’ creditworthiness, financial statements, ability to repay, and more.
Interest on working capital loans is high as they are for the short term and can sometimes be unsecured. For the term loan, the interest rate is lesser than the working capital loan. However, the business ends up paying higher interest in term loans as the interest keeps accumulating over the years.
The amount of loans under the working capital loan is usually small as businesses take this to meet the shortfall in the operating cash flow. Term loan involves large sums of money as a company takes this loan usually for expansion purposes.
The working capital loan may or may not require you to give collateral. Term loans, on the other hand, are secured loans, and thus, need to provide a collateral guarantee.
There are usually three types of working capital loans:
Accounts receivable loans – when a business uses its debtors or receivables to get the funding.
Business credit line – it is similar to having a credit card. Here, banks grant you a credit limit. You can use it regularly as long as you keep paying it back.
Factoring or advances – these are similar to accounts receivable loans. The only difference is the loan depends on the future receipts and not the receivables.
The term loan is also of three types:
Short-term loan – is usually for about a year. Generally, companies that don’t qualify for a line of credit go for this loan.
Intermediate-term loan – this loan is usually for up to three years.
Long-term loans – these loans are usually between three and ten years, but some loans may extend to 30 years.
The term loan has a better chance of improving your credit score as the loan amount is higher. Making timely payments towards term loans would mean that the borrower has adequate cash flow and income.
The type of loan you need depends on your business needs. For instance, if you need a quick loan or a small amount to meet a current business need, then working capital loan is the best option for you. But, if you are planning to expand, or boost your revenues, then you need to go for a term loan.1–4