When you need to borrow money for your business, the type of debt you take on makes a big difference. By matching up the right type of loan to your needs, you can coordinate the payments with your schedule and lower the amount you’ll pay for financing.
To help you figure out what kind of loan to take out, we’ve covered the scenarios when it makes sense to use term debt versus revolving debt.
The difference between term and revolving debt
Term debt is a loan with a set payment schedule over several months or years. For example, say you borrow $50,000 and pay the money back with monthly payments over five years. These types of loans typically have a fixed interest rate with set payments, which makes them very predictable. Typically, you can also borrow more, when you use term debt, than you can with revolving debt. However, it takes more time to qualify for term debt, especially since each loan requires a new application.
Revolving debt has some important differences. It's a loan with more flexibility about when you pay the money back -- it's like a line of credit. After you set up your revolving loan, the lender tells you the maximum you can borrow. You can borrow money whenever you need it, pay it back on your schedule, then borrow again.
Revolving debt usually requires you to pay the money back quickly, and many revolvers require that you have a zero balance at some point each year, meaning you need to pay back everything you’ve borrowed. Otherwise, the lender could charge you a penalty or even shut down your revolving line of credit.
When to use term debt
Term debt is best used for long-term investments in your business. These include projects like paying for renovations to your store or buying a new piece of machinery. These investments are one-time expenses whose launch schedule you decide on. As a result, you can plan for the longer application process for term debt.
A term loan will also spread out the payments for these expenses, which can be fairly large. This will give you the room to pay off the investment over several years so that your payments will be more manageable. Revolving debt doesn’t match up well with these projects because you might not be able to borrow enough to pay for these large expenses. You’ll also likely borrow too much to pay it back fast enough for the terms of revolving debt.
When to use revolving debt
Revolving debt is best used for your working-capital needs, like buying inventory, making payroll or handling last-minute expenses and bills. These expenses are less predictable and come up more frequently. By having a "revolver" in place, you’ll be able to borrow money quickly to pay off these expenses. Term debt has a longer application period, so it’s typically too slow for these situations.
Since these expenses are also smaller, you should be able to pay them off more quickly, so you can handle the shorter window for paying off your revolving debt. You don’t need the extra time from term debt.
The message here is: Don’t burden your company with the wrong kind of financing. By keeping these general guidelines in mind, you can put together an effective debt plan for whatever expenses come your way.