Working Capital Loan vs. Small Business Loan

gesrey/Getty Images: Illustration by Issiah Davis/Bankrate

If you’re considering borrowing money to help cover some of the regular operating expenses associated with running a business, many different options are available. The choices include a working capital loan, which is a type of short-term business loan that provides fast funding to help businesses pay for day-to-day operating costs. Here’s a look at how this type of loan compares to small business loans.

Working capital vs. small business loan

Working capital loans are a type of small business loan, typically with short repayment terms such as two years or less. Like any business loan, they can be a lump sum of cash or a revolving pool of cash you draw from as needed. What makes them different from other types of small business loans is they cover day-to-day costs, rather than funding a large, one-time purchase.

Long-term small business loans, on the other hand, cover purchases that can’t be repaid quickly. This may include equipment, investments and expenses that cover growth and expansion costs and need to be paid off over terms of three to five years or longer.

What can you use working capital loans for?

The best working capital loans can be used for various operating costs. Some of the ways the money can be used include:

• Emergencies
• Payroll
• Utilities
• Rent
• Inventory purchases
• Pay short-term debt
• Marketing
• Supplies
• Paying vendors
• Cover short-term cash flow gaps

Types of working capital loans

Working capital loans come in many different forms. Each has advantages and disadvantages worth considering before applying.

• Term loan: A term loan provides a lump sum of cash upfront that’s repaid in installments and is usually used for a specific purchase. The payments may be bimonthly, weekly, or in some cases, even daily payments.
• Business lines of credit: Using a business line of credit provides access to a revolving pool of money. The cash can be drawn from the line of credit as needed, and the credit limit available replenishes as you pay back the loan. You also only pay interest on the amount you withdraw.
• Business credit cards: Similar to consumer credit credits, a business credit card can be used daily to make necessary purchases. The credit line is typically lower than what is available through a term loan or other credit lines. But you can receive rewards for purchases or an introductory 0 percent APR.
• Microloans: Microloans provide a relatively small amount of funds, often for less than $100,000. These loans tend to relax eligibility requirements, making them accessible to startups or borrowers with bad credit.
• Invoice financing or factoring: Invoice financing and factoring taps into the value of your businesses’ unpaid invoices in exchange for cash. Invoice financing allows for borrowing against the value of invoices as a loan or line of credit. Using invoice factoring, you sell invoices to a lender for a percentage of their face value, and the lender collects the payments for you.
• Merchant cash advances: Merchant cash advances are a type of bad-credit business loan. They provide quick cash repaid with a portion of your daily or weekly sales. But since these aren’t technically loans, they skirt laws that cap maximum interest rates for borrowers. MCAs tend to come with high borrowing costs.
• SBA loans: Several types of SBA loans can be used to cover working capital costs, including SBA 7(a) loans and microloans. These loans offer low interest rates and some are open to borrowers with bad credit or limited time in business experience. These loans are backed by the U.S. Small Business Administration.

Alternatives to working capital loans

Working capital loans may not be the right choice for every business. Instead, you might look into alternatives, including:

• Long-term business loans: These loans involve a longer repayment timeline, typically five years, though some lenders may offer terms of 10 years or longer. You might need a long-term loan if you’re making a large purchase and need to keep the business loan repayments manageable.
• Grants: Depending on the type of business, you may be able to access grants from the local, state or federal government. You won’t need to repay the grant, though the grant organization may require you to pitch your business and show how you plan to use the funds. Often this type of funding targets economically disadvantaged businesses, minority-owned, veteran-owned or women-owned businesses.

Where to get a working capital loan

You can apply for a working capital loan with various lenders, including banks, credit unions and online lenders. Traditional banks often offer the most appealing interest rates, though they may have strict criteria to be eligible for the business loan. Online lenders can typically fund loans much faster than banks, but you may trade high interest rates for the fast funding and relaxed eligibility requirements. Credit lines and term loan amounts vary significantly based on the lender and their eligibility requirements. Some lenders may also require you to have a business checking account.

Bottom line

Working capital loans can provide access to cash to help cover various short-term expenses, including wages, debt, rent and utilities. Even startups or business owners with low credit scores can qualify for a working capital loan. If you’re considering this type of loan, investigate the options and find the right loan for your business’s unique needs. Key to managing your working capital loan is understanding where the money will most aid your business and plugging the loan repayment into your business budget.

Frequently asked questions

• Which is better: A term loan or working capital loan?
  

  A working capital loan is a type of small business loan that funds operating expenses over a short term. It can be a term loan, line of credit or another type of small business loan. If you choose a term loan to fund your working capital needs, you will repay the loan with interest over a set timeframe. Term loans can also be long-term, such as five years or longer. Longer terms can help you lower your monthly payments.

   

• Can SBA loans be used for working capital?
  

  Some SBA loans can be used for working capital but not all of them. SBA Express loans, microloans and 7(a) loans can be used to cover working capital needs.

• Who should use a working capital loan?
  

  Working capital loans should be used by businesses that need to cover short-term needs. This includes expenses such as payroll, rent, debt payments and utilities. You will want a solid plan to help you manage the business loan, such as adding the repayments as a line item in your budget.