Small Dollar Loan vs. Line: Which is Best for Your Business?

When business owners face financial hurdles or growth opportunities, choosing the right financing option can be a game-changer. This decision is even more critical in today’s interest rate environment, where borrowing costs are slowly beginning to come down and careful financial planning is essential. Two common solutions are small-dollar loans and lines of credit. While both serve as valuable tools, their differences make each better suited for specific situations. Let’s explore the advantages, disadvantages, and ideal use cases of each to help you decide which option aligns with your business needs.

The Basics: Small-Dollar Loans vs. Lines of Credit

A small-dollar loan is a fixed-term loan offering a lump sum of money, typically ranging from a few thousand to tens of thousands of dollars. These loans are repaid over a set period with consistent monthly payments and interest rates.

A line of credit, on the other hand, works like a credit card. It provides access to a predetermined credit limit, and you only pay interest on the funds you use. Lines of credit are often revolving, meaning you can draw and repay funds as needed, as long as you stay within the credit limit.

An example:

An owner of a tutoring service sees an opportunity to meet increasing demand by investing in newer technologies for virtual tutoring and to hire an additional part-time tutor.  A short term loan would allow the owner to cover larger up-front technology and software expenses with the benefit of predictable payments, while a line of credit could be used to draw an initial amount that covers the tech upgrades while reserving capital to support greater marketing needs and the potential onboarding of the part-time tutor as business increases.

Before we find out what worked best for the tutoring service, let's look at some general pros and cons of each product type.

Pros & Cons of Each

Small Dollar Loans

Advantages:

1. Predictability: Fixed payments and interest rates make budgeting easier.
2. Larger amounts available: Small-dollar loans often provide more funding than lines of credit for specific needs.
3. Structured use: These loans are ideal for one-time expenses like equipment purchases or office renovations.

Disadvantages:

1. Less flexibility: Funds are disbursed as a lump sum, and you cannot borrow more without reapplying.
2. Strict approval criteria: Qualification often depends on your credit score, revenue, and business plan.

Lines of Credit

Advantages:

1. Flexibility: Draw funds as needed and pay interest only on the amount used.
2. Ongoing access: Once approved, funds are available without the need to reapply.
3. Versatility: Ideal for managing cash flow or covering unexpected expenses.

Disadvantages:

1. Variable costs: Interest rates are often variable, and monthly payments can fluctuate.
2. Discipline required: Without careful management, it’s easy to accumulate debt.
3. Lower borrowing limits: Lines of credit generally provide less capital compared to small-dollar loans.

When to Use a Line of Credit

A line of credit is best suited for businesses that need a safety net for short-term cash flow issues or fluctuating expenses. For example:

• Seasonal businesses: Retailers or landscapers with peak seasons often use lines of credit to cover inventory or payroll during slower periods.
• Unexpected costs: Emergency repairs or temporary dips in revenue can be managed with quick access to funds.
• Working capital needs: A line of credit can cover everyday expenses like rent, utilities, or supplier payments when cash flow is tight.

However, lines of credit are not a long-term financing solution. If you find yourself repeatedly drawing the full amount without paying it down, it might be time to consider other financing options.

When to Consider a Small-Dollar Loan

Small-dollar loans are ideal for planned, one-time expenses or specific projects. Scenarios where a loan might be the better choice include:

• Equipment purchases: Financing new machinery or tools with a fixed loan ensures predictable payments.
• Expansion projects: Adding a new location or renovating a storefront often requires a larger, fixed sum.
• Debt consolidation: Small-dollar loans can simplify multiple debts into one manageable payment, often with a lower interest rate.

When to Explore Other Financing Options

While small-dollar loans and lines of credit are versatile, some situations call for alternative financing. Here are a few examples:

1. Equity Financing: Startups or businesses in growth stages may attract investors willing to exchange capital for equity in the company.
2. Merchant Cash Advances: These provide quick funds based on future credit card sales but come with higher costs and fees.
3. Invoice Factoring: If unpaid invoices are holding up cash flow, selling them to a factoring company can provide immediate funds.
4. SBA Loans: SBA loans, which offer competitive rates and longer terms for eligible businesses, are particularly helpful for businesses investing in real estate, equipment, or working capital.

Key Considerations for Choosing the Right Option

When deciding between a small-dollar loan, a line of credit, or alternative financing, ask yourself:

• What is the purpose of the funding? For specific projects, loans are often better. For cash flow management, lines of credit excel.
• How much flexibility do I need? If you’re unsure of the exact amount you’ll need, a line of credit offers more adaptability.
• Can I manage the payments? Fixed payments offer stability, but variable payments require careful planning.
• What’s my financial timeline? Short-term needs are ideal for lines of credit, while long-term investments suit small-dollar loans.

Example Revisited

In our example above, the tutoring service chose a business line of credit. Its flexibility lets the owner cover both planned expenses and unexpected opportunities. They drew on the credit line to invest in the new virtual tutoring platform and kick off a small marketing campaign. A few months later, when demand for SAT prep increased, they tapped the credit line again to hire an additional tutor and purchase new educational materials.

With the line of credit, the owner felt the business could grow steadily without overcommitting financially.

What works for you?

Choosing the right financing option can significantly impact your business’s success. Small-dollar loans and lines of credit each serve unique purposes, and understanding their advantages and disadvantages is key to making an informed decision. Additionally, exploring alternative options like SBA loans, equity financing, or invoice factoring can open doors to the capital you need.

Whether you’re planning for growth or addressing unexpected challenges, the right financial solution is out there – and a local banker with expertise in small business lending can help you find it.

About the Author: Michael Johnston is the Head of SBA Lending at Bankwell. With over 20 years of experience in banking and lending, Michael has a deep understanding of the challenges business owners face.