Business Term Loan and Working Capital Loan: What’s the Difference?
Knowing the differences between term loans & working capital loans helps you make better decisions. Read on to know the 8 key differences at IIFL Finance.
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
Working Capital vs Term Loan – DifferencesDifferences between term loans and working capital loans are as follows:
1. DurationA 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. InstallmentsBecause 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. PurposeTerm 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 RateAs 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 LoansWhen 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.