A line of credit covers a timing gap: the money is coming and you do not have it yet. A term loan buys something that earns its keep over years, such as a truck or a build-out. Use the line for receivables that pay in 60 days and payroll due before then. Use the term loan for anything you would still be paying for after the gap closes. Line of credit versus term loan turns on the length of the gap. If you cannot say when the line will be back to zero, you are looking at a loss, not a timing gap, and a line only hides a loss.
The two instruments side by side
A line of credit is a limit the bank agrees to lend up to, usually for a year at a time. You draw what you need, repay it when cash comes in, and draw again. Interest is charged only on the drawn balance, almost always at a variable rate tied to prime. The bank renews it each year. Or it declines to.
A term loan is a fixed sum, paid out once, repaid in equal installments over a set number of years. Interest runs on the whole balance from the first day, at a fixed or variable rate. There is no renewal because there is a schedule, and the schedule is what your debt service coverage is tested against.
| Line of credit | Term loan | |
|---|---|---|
| How you get the money | Draw as needed, up to a limit | One payment at closing |
| How you repay | Whenever cash comes in; revolves | Fixed monthly installments |
| Interest charged on | Drawn balance only | Full balance from day one |
| Rate | Usually variable (91% of usage, per the Kansas City Fed) | Fixed or variable |
| Term | Typically one year, renewed at the bank's option | Two to ten years, or longer for property |
| Fees | Draw fees, inactivity fees, renewal fee | Origination fee, sometimes prepayment penalty |
| Security | Often receivables and inventory, plus a personal guarantee | The asset bought, plus a personal guarantee |
Chase's guide for business customers frames it as most banks do: lines for payroll, rent and stocking up on inventory, loans for large, strategic investments. That is right as far as it goes, but it does not cover the case where payroll needs the line every other Friday and the balance climbs a little each time, which is where owners get into trouble.
What banks are charging
The Federal Reserve Bank of Kansas City's Small Business Lending Survey for the fourth quarter of 2025, published on 26 March 2026, covers the banks a 30-person company actually borrows from. Median rates on new term loans were 6.75% fixed and 7.00% variable at urban banks, 7.14% and 7.19% at rural ones. New lines of credit were priced at 6.65% fixed and 7.09% variable at urban banks, 7.36% and 7.50% at rural. At signing they cost about the same. The difference is that about 91% of line usage is at a variable rate, so a line's cost follows prime, while a fixed term loan does not.
On the borrower side, the Federal Reserve Banks' 2026 Report on Employer Firms, published 3 March 2026 from a 2025 survey of 6,525 firms, found that 38% had applied for a loan, line of credit or merchant cash advance, that 56% of those seeking financing wanted it to meet operating expenses, and that only 42% received everything they asked for. Among firms with debt, 59% had given a personal guarantee, which makes the choice of instrument a choice about what your house is standing behind.
Four gaps, and which instrument fits each
First, a slow receivable. A mechanical contractor with 34 staff is owed $148,000 on a pay application that will clear in about 45 days, with payroll due twice before then. That is a line. Draw $110,000, repay it the day the check lands, and the interest at 7.09% for 45 days is around $960. A term loan would leave the company repaying for years against money that came back in six weeks.
Next, a seasonal trough. A landscaping company with strong revenue from April to November runs ten weeks in winter with costs and little coming in. The 2016 JPMorgan Chase Institute study of 597,000 firms found the median small business held 27 days of cash, so most cannot ride out ten weeks from reserves. That is a line too, on one condition: the season that follows must repay it in full. If last winter's draw was still outstanding when this winter started, the line is covering something other than a season. Seasonal cash planning is about proving that condition before you draw.
Third, a $68,000 truck. The truck earns over five to seven years. Put it on the line and the line never returns to zero, and you have paid a floating rate on a fixed asset. That is a term loan, matched to the truck's life, and buy or lease a work truck covers the cash math.
Fourth, a $400,000 second location: a term loan, or an SBA 7(a) loan. Under SOP 50 10 8, in effect since 1 June 2025, a standard 7(a) loan needs debt service coverage of 1.15x, measured with the new loan's payments included. If your line is already drawn to fund the first location's slow receivables, its interest is in that calculation, and the bank will ask why a business that needs its line every month wants a second site.
The rest period rule
A line should return to zero, and stay there, for some stretch of every year. Banks call this a rest period, and many write it into the agreement as a 30-day clean-up. A line that never rests is a term loan with a worse rate, no fixed schedule, and a renewal the bank can refuse. It is also the clearest sign a lender has that the business is losing money. A timing gap closes. A loss does not.
Debt service coverage ratio is cash available for debt service divided by the principal and interest due in the same period. A drawn line adds its interest to the denominator. The annual review of a line looks at three things: that ratio, the line's usage pattern over the year, and the AR aging that is supposed to justify the draws. If the aging shows the same customer at 90 days every quarter, the line is funding that customer, and the bank may prefer to fund something else. The full ratio, and what banks require, is in debt service coverage ratio for business owners.
Most guides say a line is for working capital, and we disagree with the word, because working capital in a growing business is a permanent need, and permanent needs are what term debt is for; a line should fund a gap you can put a date on.
Several companies, one line
Owners with several companies usually hold the line in the operating company with the receivables, with cross-guarantees from the rest. The trouble starts when the drawn line is lent to a sibling company. The operating company carries the liability and the interest, the sibling has cash it did not earn, and the intercompany receivable between them is often never booked. The operating company's DSCR falls because of interest on money it did not use, and the sibling's books show cash the bank would not recognize. Both sets of books are wrong in ways that show up when the bank builds a global cash flow analysis across all of them, which it will.
If the sibling needs the money, the cleaner answer is its own facility, or a documented loan between the companies with a rate and a repayment date, so the rest period can be enforced on both sides.
Navigator's Pro plan builds a 13-week cash plan from each QuickBooks Online file, so the size of a gap and the date it closes are visible before you borrow for it, and it computes break-even and coverage against the loan terms you enter, per company and consolidated, so a proposed draw or a new term loan can be checked against your DSCR ahead of the bank's review. Plan details are on the pricing page.
Seeing the gap before you borrow for it
The length of the gap is the whole decision. Only a forecast gives it to you. A 13-week cash forecast built from the AR aging, the payroll calendar and the known bills shows the week the balance dips and the week it recovers. If the recovery week is on the page, the line is the answer and the draw size is the depth of the dip. If the balance does not recover inside the 13 weeks, or recovers only because the forecast assumes sales that have not been sold, no instrument fixes that. A term loan buys time and adds a payment. A line hides the loss for a year and then fails to renew.
What the forecast cannot do is tell you what the customer will actually do. A 45-day receivable can become a 75-day one, and the draw grows with it. Nor can it tell you whether the bank will renew. Those risks come with either instrument, which is one more reason to keep the line rested for part of the year and the term debt matched to things that last.
Questions owners ask
What is the difference between a line of credit and a term loan?
A term loan is a fixed sum, paid out once and repaid on a schedule over a set number of years, with interest on the whole balance from day one. A line of credit is a limit you draw against as needed, repay when cash comes in, and draw again, paying interest only on what is outstanding. The loan buys things and the line bridges dates.
Is a line of credit better than a loan for a small business?
Neither is better. They answer different questions. If the money is for a receivable or a seasonal dip and will be repaid within months, the line is cheaper and simpler. If it is for a truck, a build-out or an acquisition that earns over years, a term loan matches the repayment to the asset's life. A line used for a long-lived purchase never returns to zero and the bank notices at renewal.
Can I use a line of credit for payroll?
Yes, and it is one of the most common uses, provided the draw is repaid when the customers behind that payroll pay. The test is whether you can name the invoices that will clear it. If payroll needs the line every fortnight and the balance climbs, the line is funding a loss rather than a timing gap, and the fix is in pricing or costs, not in a bigger limit.
What interest rate do banks charge on a business line of credit?
The Federal Reserve Bank of Kansas City's Small Business Lending Survey for the fourth quarter of 2025, published in March 2026, put the median rate on new lines at urban banks at 6.65% fixed and 7.09% variable, and at rural banks 7.36% and 7.50%. About 91% of line usage is variable, so the rate you pay next year depends on where prime goes.
Does a line of credit hurt my DSCR?
The interest on it lands in the denominator, and a line that stays drawn all year adds a full year of interest. Some lenders also count a permanently drawn balance as term debt and impute principal. A line that returns to zero for a stretch each year costs little coverage. One that never does can drop a ratio from 1.4 to under 1.2 with no change in the business.
Related
If the gap you are trying to size comes from slow customers, the AR aging report explained shows where the money is stuck. Before a term loan of any size, debt service coverage ratio for business owners is the number the bank will compute first. And if the forecast is the part you have never built, the cash flow forecast that takes an hour is the place to begin.
If you would rather see the gap and its closing date for each company every morning, the free trial connects to QuickBooks Online read-only in a few minutes and needs no card: navigatorhq.ai.
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Published . Last updated . Reviewed by a CFO on the Navigator team.