Working capital loans and term loans are both meant to increase revenue but each option is best for different types of expenses. Applicants must determine whether the expense in question is a necessity for survival or a growth opportunity as well as how quickly the expense can be paid off.
Before explaining which situations call for each option, it’s important to note the main differences between the two.
A working capital loan is a short-term business loan, meaning it must be paid back in as little as four months. It is designed to cover day-to-day operations and regular expenses, so the amount you are provided is based on the cost of running your business. Interest rates are higher than average since the amount can be as low as a few thousand dollars.
As long as it is paid back on time, working capital loans can be taken out as many times as your business needs them.
A standard term loan is paid back over the course of one to five years. It is designed to cover expensive investments that will significantly increase revenue over time. The amount is based on the projected return on the investment, which can be as high as $5 million.
These are the only fixed aspects of the two options. Payment methods, the need for collateral, and whether the interest rate is fixed or variable depends on the lender.
A Hiccup Here And There
The definition of working capital loan suggests that it should be used to keep a floundering company afloat, but this couldn’t be less true. You should only be taking out a small business loan if you intend to increase revenue to the point where paying off the debt is not a problem. If you use a business loan solely to pay your bills, what happens when the loan runs out?
A working capital loan is meant to cover the cost of running a business but only because the funds you would usually use for this purpose are tied up in some endeavor that will build or at least stabilize revenue.
Say, for example, you run an auto repair shop, and your latest job requires you to order thousands worth of car parts. A working capital loan would allow you to complete this lucrative job but not risk the inability to pay your bills or your employees at the end of the month. The customer would pay you immediately after the job is done, giving you plenty of money to pay off the loan.
Another situation that calls for a working capital loan is seasonality, which is an increase or decrease in sales certain industries experience during different times of the year. If your business performs best during the holidays, you’d have to ramp up advertising and buy more inventory during the slow season, when sales are down. With a working capital loan, you could cover these two expenses but not have to raise prices or make other changes to compensate for the lack of sales. The holiday season is right around the corner, so payments would not be an issue.
The Opportunity Of A Lifetime
Some of the most lucrative investments take time to pay off, and that’s when a term loan comes in. Payments are lower and will be easily offset by the substantial boost in revenue produced by the investment.
These investments could include buying new equipment, launching a marketing campaign or securing additional property. It could take months for you to see a return but you wouldn’t be making these investments unless you were positive your business has generated enough demand to match their cost. So while a working capital loan is tailored for minor expenses with temporary results, a term loan is tailored for major expenses with long-term results. You should only take out a term loan if your business is ready to take on a new level of demand and spend several years mounting an attack on the competition.
Term loans can also lead to a larger boost in credit score than a working capital loan. Even if they are paid back on time, taking out multiple working capital loans instead of a single term loan could actually do your credit score more harm than good. Paying off a term loan, on the other hand, will build your credit history with business lenders, positioning you for an even larger loan with better terms in the future. A second term loan will likely be necessary if you plan on maintaining your status as an industry leader.