Line of Credit vs Term Loan: When One Can Cost More

Money talks, but the fine‑print screams. Small businesses chase financing, then discover a $2,000 surprise in the first year. The choice between a line of credit and a term loan decides whether that surprise is a bump or a break.

Can a revolving line replace a big purchase without overpaying?

A line of credit lets you draw up to a pre‑approved limit, repay, and draw again. If you need $30,000 for inventory that turns over every quarter, the interest only accrues on the amount actually used. Lenders typically quote APRs from 6 % to 30 % for lines, with a 0‑to‑$500 annual fee. The variable rate can swing monthly, so a spike of 3 % adds $90 to a $30,000 balance in one month.

If the same $30,000 is taken as a five‑year term loan, the interest spreads over 60 payments. Fixed APRs hover between 8 % and 25 %, and many lenders tack on a 1‑to‑5 % origination fee. The result is a higher total cost when the business would have paid off early, because the loan forces you to pay interest on money you might not need after the first year.

Are term loans a trap when you need flexibility?

Term loans lock you into a schedule. The monthly payment includes principal, so the balance shrinks predictably. However, prepayment penalties are common; some contracts charge 1 % of the remaining principal if you pay off before month 24. For a $50,000 loan, that penalty can be $500 even if you clear the debt in six months.

A line of credit rarely imposes a prepayment penalty. You can pay down the balance to zero and still keep the credit line active. The trade‑off is the possibility of a rate reset after six months, which can push the effective APR higher than the original quote.

What APR numbers really mean for each product?

Advertised APRs ignore fees. Add a $250 setup fee to a $20,000 line and the effective APR climbs by roughly 0.5 % points. For a term loan, a 2 % origination fee on a $20,000 loan adds the same 0.5 % points. The real difference emerges in utilization: a line used at 20 % of its limit for six months costs far less than a loan that forces you to carry the full amount for the same period.

If you run the numbers, a $20,000 line at 12 % APR, 20 % utilization, and $250 fees costs about $240 in interest the first year. The same $20,000 term loan at 14 % APR, plus a 2 % origination fee, costs roughly $1,800 in interest and fees over the first year. The gap widens if the line’s rate jumps to 18 % after the introductory period.

Which lender clauses bite the most?

Look for “rate floor” language in line agreements. Some banks set a minimum 9 % rate even after a teaser period, turning a seemingly cheap line into a costly one. Term loan contracts often hide “default interest,” which can double the rate if you miss a single payment.

Another sneaky provision is “minimum draw.” Certain lenders require you to take at least 30 % of the approved credit line, effectively forcing a loan you might not need. That clause inflates the effective cost because you start paying interest on money you never intended to use.

Action steps: size up the true cost before signing

1. Write down the advertised APR, any setup fee, annual fee, and possible prepayment penalty. 2. Estimate how much of the line you’ll actually draw each month. Use the formula *interest = balance × APR ÷ 12*. 3. For a term loan, calculate the monthly payment with a standard amortization calculator, then add the origination fee divided by the loan term. 4. Compare the two totals over a 12‑month horizon. If the line’s projected interest plus fees exceeds the loan’s total cost, the loan wins. 5. Contact the lender’s compliance department and ask for a copy of the rate reset schedule and any “minimum draw” clause.

A realistic cost range for a $50,000 line is $500‑$2,500 in the first year, depending on utilization and rate changes. A comparable term loan usually lands between $1,200 and $3,500 total, after fees and interest.

Final checklist before you wire any cash

• Verify the exact APR after any introductory period.
• Confirm whether the rate is truly fixed or tied to a benchmark like LIBOR.
• Scrutinize the contract for any “minimum draw” or “early termination” fees.
• Ask the lender to spell out the prepayment penalty in dollars, not percentages.
• Double‑check that the disclosed fees match the numbers on the closing disclosure.

If any of those items raise a red flag, walk away or renegotiate. A financing decision that looks clean on the surface can turn into a hidden‑cost nightmare in six months. Know the math, read the fine print, and let the numbers decide which product fits your business reality.