Term Loan Vs Working Capital Loan: Key Differences for Business Owners

Every organisation, regardless of size, depends on different sources of credit to succeed and grow. They use this money to finance their daily activities, such as paying rent, replenishing supplies, covering employee salaries, or expanding.

The two broad categories of a business' funding needs are working capital loans and term loans. Understanding the differences between term loans and working capital loans can help you make better business decisions.

What Is A Working Capital Loan?

Working capital loans are short-term loans businesses use to finance their daily expenses. They include paying rent on time, employee salaries, or covering last-minute seasonal demands. This external funding helps businesses get back on track and operate smoothly.

A good feature of this loan is that a business can use it as much as necessary, as the only requirement for its approval is timely repayment.

However, a working capital loan isn't used to make new investments, start new projects, or expand an existing business. This loan usually lasts one year or less as a short-term loan.

What Is A Business Term Loan?

The purpose of business term loans is to finance long-term investments, such as expanding your business or investing in new machinery or tools. Unlike working capital loans, these loans typically involve higher amounts of money, which is why they are paid back over a more extended period.

Term loans, however, have an interest rate that increases over time, making them costlier than working capital loans.

Since the loan is long-term, obtaining it isn't easy. Financial institutions examine the borrower's profile and credit history to approve or deny a loan application. When approving a loan, lenders consider the following factors:

• Bank statements of the applicant
• The reputation of the company in the market
• Repayment capacity of the borrower
• Credit rating
• Collaterals

Working Capital vs Term Loan – Differences

Differences between term loans and working capital loans are as follows:

1. Duration

A working capital loan is short-term and has a few months of the repayment period. Meanwhile, term loans can be short-term, medium-term, or long-term. Term loans are usually between one and ten years, but they can last up to 30 years.

2. Installments

Because term loans are long-term loans, they are repaid in many installments. On the other hand, working capital loans have limited repayment installments because of their small amount.

3. Purpose

Term loans are usually used for expansion plans, purchasing equipment and machinery, and renovating office premises. However, working capital loans are commonly used to tide over cash crunches during the day-to-day operations of a business.

4. Interest Rate

As working capital loans are short-term and often unsecured, the interest rate is high.

The interest rate on a term loan is lower than that on a working capital loan. However, the interest accumulated on term loans leads to higher interest payments over time.

5. Ease Of Getting Loans

When a business has a good credit rating, working capital loans are easy to obtain. In addition, the loan is short-term, so there is little paperwork.

Contrarily, there are many procedures and paperwork involved in a term loan. Lenders must thoroughly check borrowers' creditworthiness, financial statements, ability to repay, and other factors before approving or rejecting their loan requests.

6. Loan Amount

Most businesses take a working capital loan to meet a shortfall in operating cash flow, so the amount is usually small. When a company takes out a term loan, it usually does so for expansion purposes. Hence, these loans usually involve large sums of money.

7. Collateral

There may or may not be a collateral requirement for the working capital loan. In contrast, term loans are secured loans that often require assets as collateral.

8. Credit Score

Since term loans have a higher amount, they are more likely to improve your credit score. When a borrower pays on time, it shows that they have adequate income and cash flow. Working capital loans, however, do not improve credit scores in the same way.

Which Finance Option Is Better?

Despite their different types, both loans offer lucrative features and terms essential for proper business operation. A business term loan is usually the better option for ventures requiring heavy investment. Nevertheless, working capital loans are an excellent option if the company only needs a small amount to cover its operational expenses.

Obtain A Business Loan From IIFL Finance

If you lack the funds to grow and expand your business, IIFL Finance business loans can help you fund your next capital venture. Our business loans are tailored to the unique needs of your business, and repayment terms are favourable. Additionally, our documentation process is straightforward, resulting in faster loan disbursal. For further information, visit the IIFL website now!

Frequently Asked Questions

Q1. Does a working capital loan require collateral?

Ans. No, you don't necessarily need to lend an asset as collateral to obtain working capital credit.

Q2. Does a term loan provide any tax benefits?

Ans. Yes, you can deduct interest on term loans as a business expense. By doing so, the business can take advantage of tax benefits.