Bank Loans vs. Lines of Credit

There is a common financial principle called "The Matching Principle." This is the concept that you need to match your type of financing with the type of asset you want to purchase. This is easily seen when you use debt funding. For instance, if you want to purchase a new grill for your restaurant, what kind of deal do you look for? What if you want to purchase a building and land? There are 2 main ways that you can fund purchases with debt funding: traditional bank loan or a line of credit.

Bank Loan

We all know what a bank loan is. You might have one for your car, your home, your credit card consolidation, etc. There is a set interest rate and a set period of time until the loan should be repaid. With this, there is usually an amortization schedule given to you so you know what payments will need to be made each month. A bank loan can be a short-term loan (1-5 years) or a long term loan (5+ years).

When you look at the matching principle, you want to fund short-term assets with short-term debt financing. For example, if you need to purchase office supplies for your business (short-term assets), you will want a 1-2 year bank loan (short-term financing). On the flip side, if you purchase a building (long-term asset), you will want a 10 year+ bank loan (long-term financing). If you do not follow the matching principle and you finance a long-term asset with short-term financing, you can mess up your cash flow and find yourself struggling to make payments. A short-term loan can be useful if you know exactly what short-term assets you want to purchase and can justify how those short-term assets will bring about a positive change in the business. What about those purchases that you have no clue how to project and could be seasonal expenses? A line of credit could be a perfect fit for you.

Line of Credit

A line of credit is a excellent option for seasonal businesses or those businesses who need short-term financing. A business who might need some additional cash to help make purchases during their peak time, a line of credit would be a perfect option, because they do not borrow more money than they need. A line of credit works very similar to a credit card; you only pay back interest and principle once you borrow (take a draw) the funds. A line of credit will give you a credit limit (the maximum amount you can borrow) and will not charge you interest on money you do not draw on. There are some differences between lines of credit structures with different banks, but most operate the same way. 

DO NOT use a line of credit to support a long-term asset. Lines of credit are perfect for inventory control, emergency funds, or seasonable businesses. If you are purchasing a long-term asset, you will want to look at a traditional long-term loan. A line of credit is a revolving fund, and should not be tied up to a long-term investment. Always remember the matching principle when you are looking for fund purchases: support short-term assets with short-term financing, while support long-term assets with long-term financing.