What is the Difference Between a Working Capital and Term Loan?

Oct 28, 2021 | 0 comments

Most businesses will need help financing their company at one time or another. Whether you’re looking to scale inventory or trying to cover payroll until a big deal closes, you may need financial support.

Working capital and term loans are two of the more common types of business financing that you may encounter when considering the best funding option for your company. To truly understand the differences between a working capital and term loan, we need to take a deep dive into each.

What is a Term Loan?

A term loan allows a business owner to borrow money with a fixed interest rate from a lender that is then repaid over a set period of time — usually one to ten years. Businesses typically apply for a term loan when they need to make a large upfront investment. 

Borrowers will be responsible for repaying the full loan amount plus interest and fees over the life of the loan. Some term loans allow you to repay them early without penalty, but others may have prepayment fees.

Term loans usually come with more favorable conditions than other funding options. Below are some of the benefits to business term loans.

  • Term loans have lower interest rates: Unlike other business loans or lines of credit, term loans usually have lower interest rates because they have longer repayment periods and a more stringent application process.
  • Term loans have less restrictions: Many types of business financing come with limitations on how the funds can be used, but term loans typically do not. Business term loans are one of the most flexible funding options available.
  • Term loans are fixed: Predictability is another benefit to a business term loan. The payment structure of term loans usually require the same monthly payment for the life of the loan which makes it easier for you to plan financially.

How Are Term Loans Used?

Because term loans are flexible, you can use the funds to cover almost any business expense. From purchasing materials and inventory to funding expansion projects, a business term loan can provide the extra capital needed.

Borrowers often use term loans to cover large investments in their business. For example, if you ran a t-shirt printing company and wanted to purchase a new screen printer for $30,000, you could use a 5-year term loan to cover the cost of the printer and repay that loan over five years.

The 3 Types of Business Term Loans

A term loan is a comprehensive name given to business loans that are repaid over a set period of time. However, borrowers should know that there are three different types of business term loans:

  • Short-term loan: A short-term business loan is usually repaid within 3 to 36 months. These types of term loans are usually for emergencies or when businesses need quick cash. Like other short-term financing options, these loans come with higher interest rates.
  • Medium-term loan: A medium term loan usually matures within 2-3 years and has a slightly lower interest rate than a short-term loan.
  • Long-term loan: Generally, a long-term loan will run between 3 to 10 years. These types of business loans are usually for larger purchases and have lower interest rates because of their length.

What is a Working Capital Loan?

A working capital loan is short-term financing for businesses to manage their business operations. It’s designed to help cover day-to-day business expenses that you would typically pay with working capital.

But, what is working capital? Working capital is simply a business’s short-term liquidity or the cash it has readily available for everyday expenses. The formula for working capital is:

Working Capital = Current Assets – Current Liabilities

A working capital business loan is not meant for large purchases and is due for repayment within one year. It also has higher interest rates than other business funding options.

Below are some of the benefits to working capital loans.

  • Working capital loans are easier: Compared to other business financing options, a working capital loan has fewer qualifications and an abridged application process.
  • Working capital loans are faster: Because these loans are meant for emergencies, businesses can usually get approved and funded quickly.
  • Working capital loans encourage early repayment: While some business loans penalize the borrower for repaying early, working capital loans tend to prefer early repayment. Not only can repaying your working capital loan early benefit your relationship with the lender, but it can benefit your business credit score, too.

How Are Working Capital Loans Used?

As the name suggests, a working capital loan is used for working capital exclusively. In other words, it can only be used to cover operating costs like rent, utilities, payroll, and cash flow management.

For example, many retailers operate a seasonal business which means they earn a majority of their annual revenue in the fourth quarter of the year. This revenue discrepancy creates ebbs and flows within its cash flow and can make it difficult to finance the business during slow seasons. A working capital loan can help mitigate this by giving you the cash needed to keep your business moving forward.

3 Types of Working Capital Loans

A working capital loan comes in many shapes and sizes, but below are three of the more common types of working capital loans.

  • Short-term loan: A short-term business loan can also be a working capital loan. However, many small businesses looking for quick cash may struggle to get approved for a short-term loan from a bank.
  • Business line of credit: Businesses that get approved for a working capital line of credit can tap into a large pool of cash as needed. When you have cash flow gaps, you can use this line of credit, and you are only obligated to pay on the cash that you take out.
  • Invoice financing and factoring: Unfortunately, late and delinquent invoices are a part of running a business. However, businesses can take advantage of invoice financing or factoring as a way to trade in these outstanding invoices for working capital. 

Is a Working Capital Loan the Same as a Term Loan?

A working capital loan is not “exactly” the same as a term loan. While a short-term loan can be used as a working capital loan, a typical term loan and a working capital loan have vastly different purposes, qualifications, and uses.

Term Loan vs. Working Capital Loan: Purposes 

A working capital and term loan differ on the underlying purpose of each loan. 

The purpose of a term loan is to help businesses scale. Lenders want to give borrowers a lump sum to help them finance the growth of their operations. When the business grows, so too does the relationship — and the interest payments. Traditional lenders also prefer medium- and long-term loans over shorter ones because it brings in more money over time and offers more stability.

The purpose of a working capital loan is to help mitigate cash flow gaps within the business. Lenders provide working capital loans as a short-term solution for businesses without enough cash to cover their immediate expenses. Traditional lenders typically avoid these short-term loans because it can be riskier, and the other working capital financing options hedge that risk with higher interest rates.

Term Loan vs. Working Capital Loan: Qualifications
Another difference between working capital and term loans are the requirements and qualifications of each.

The qualifications for a term loan are much more intense than most working capital loans. Lenders will often require extensive paperwork and will check your credit, financial records, and background. Based on the size of the term loan, you may also need to provide collateral.

The qualifications for a working capital loan are much more lax. Depending on the type of working capital loan, you may have access to funds within a few hours with minimal requirements (i.e. business credit card). While ease and speed is great, it may cost you in the form of higher interest payments.

Term Loan vs. Working Capital Loan: Uses 

Working capital and term loans are also used differently.

A term loan can be used for anything related to the business. This includes common expenses like rent and wages, but also more complex investments like opening a new location or investing in materials. 

A working capital loan is used strictly for day-to-day operations. This type of loan is reserved for emergencies and costs needed to keep the business running. It can cover utilities, payroll, and other necessary business expenses.

Working Capital and Term Loans Are Both Important

Working capital and term loans are just two of the many important ways businesses finance their operations. One financing option isn’t necessarily better or worse than the other. Instead, businesses considering a working capital and term loan should look at their situation and choose the business financing option that aligns best with their current needs.

This post was originally published on What is the Difference Between a Working Capital and Term Loan? on Fundbox.- Fundbox – Fundbox Forward

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