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. 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 loans is they cover day-to-day costs and they’re short-term, typically repaid in less than two years. Long-term 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. 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. This type of borrowing typically comes with a variable interest rate.
• 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.
• Microloans: Microloans provide a relatively small amount of funds, often for less than $100,000.
• 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.
• 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.

Alternatives to working capital loans

Working capital loans often come with higher interest rates and shorter repayment timelines than other types of borrowing. So applying for one may not be right for everyone. But working capital loans are merely one borrowing option. Some of the additional types of funding that may provide a viable option include:

• 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.
• Grants: Depending on the type of business, you may be able to access grants from the local, state or federal government. Often this type of funding targets economically disadvantaged businesses, minority-owned, veteran-owned or women-owned businesses.

Where to get a working capital loan

Various lenders offer working capital loans, including banks, credit unions and online lenders. Traditional banks often offer the most appealing interest rates, while online lenders can typically fund loans much faster. 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 working capital. 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 having a budget and understanding where the money will most aid your business.

Frequently asked questions

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

  Deciding which loan is better will depend on your business’s finances and needs. A working capital loan typically has a short repayment timeline and may have a much higher interest rate. A term loan offers a longer repayment timeline and the borrowing amounts are often far higher, which may be better if you have a more significant expense to cover.

• 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.