Working Capital Loans vs Term Loans

So, you’ve decided to get a small business loan… but you’re not sure about the right type of loan for your needs.

You may have heard about working capital loans and term loans.

In this article, you’ll learn:

• What a working capital loan is
• What a term loan is
• Differences between working capital loans and term loans
• Pros and cons of both types of loans
• How to decide between a working capital loan and a term loan

What is a Working Capital Loan?

A working capital loan is used by companies to satisfy short-term financial obligations, not long-term needs. There are various working capital financing options, including merchant cash advances, invoice financing, and business credit cards.

Note: working capital is calculated by taking current assets (such as cash, accounts receivable, and inventory) and subtracting current liabilities (such as accounts payable, wages payable, and short-term debts).

What is a Term Loan?

A term loan provides the borrower with upfront cash to be repaid on a fixed schedule. The repayment period can be as little as one year or as long as 25+ years.

Since a term loan can be short-term or (very) long-term, it can be used for short-term needs such as purchasing inventory or long-term needs such as buying property.

Working Capital Loans vs Term Loans

Let’s look at the differences between working capital loans and term loans.

Repayment Terms

Working capital loan: this is typically used to cover a business’s needs over the next year. So, a working capital loan is likely to have a duration of one year or less. And with certain types of working capital loans – such as a merchant cash advance – the payments adjust with the ebbs and flows of the small business’s sales.

Term loan: this is typically used to cover a business’s long-term needs. So, the duration is several years in many cases. The repayment terms are not flexible, as payments are due on a set schedule.

Reason

Working capital loan: as the name suggests, this is used to cover working capital needs. For example, a working capital loan could help you build your inventory ahead of the holiday season.

Term loan: it’s possible to use this financing option for short-term needs. But term loans really shine as a way to purchase expensive equipment or real estate because you can spread the (large) cost over a long period of time – creating a manageable monthly payment.

Amount

Working capital loan: typically, the loans are on the lower end – a relatively small amount is often enough to cover working capital needs.

Term loan: the amounts are very large, in some cases, as term loans are used to cover high-value long-term assets.

Interest Rates

Working capital loan: typically, a working capital loan has a high interest rate – or effective interest rate. With that said, the dollars paid in interest/fees might be low – even if the annualized rate is high – due to the short repayment terms.

Term loan: this has a relatively low annualized interest rate, in many cases.

Pros and Cons of Working Capital Loans

Here are some pros and cons of working capital loans:

Pros

1. Quick funding: get money in your account within a few business days.
2. Flexible repayments: some working capital financing options allow you to repay the funds with the ebbs and flows of your business.

Cons

1. High annualized rates: you might have to pay a lot of money in interest/fees on an annualized basis.
2. Lack of flexibility on use-cases: a working capital loan is not a viable option for long-term business needs, such as expensive equipment and property.

Pros and Cons of Term Loans

Here are some pros and cons of term loans:

Pros

1. Low annualized rates: you can secure a low interest rate, in many cases.
2. Flexibility on use-cases: a term loan can be used for both short-term and long-term business needs.

Cons

1. Slow funding: in many cases, it takes a long time to get funding – particularly with a bank.
2. Set repayment terms: your payments don’t change if your business goes through a rough period.

The Bottom Line

For a small business owner with long-term needs, a term loan is likely the best option.

For a small business owner with very short-term needs (e.g., two months), a working capital loan is likely the best option.

But what if you need funds for approximately one year?

In this case, you should look at a few offers – both working capital loans and term loans – and compare them head-to-head.

If you’ve decided to use a working capital loan, consider Gravity Capital.

Or if you need help assessing your options, give us a call at 866-701-4700.