Knowing which type of lending arrangement suits which set of economic circumstances can make a critical difference to maintaining your business during an economic downturn, and being able to make investments and acquisitions for the future.
Businesses will typically have a mix of loans and credit facilities at different points in their lifecycle. In this article, we explain the difference between loans and credit facilities and expand on the advantages and disadvantages of each one.
What are the key terms of a loan?
A loan is typically used for specific and larger investments or acquisitions, such as premises, equipment and other assets, a business or a company, although they can be used for working capital.
The basics of a loan are as follows:
- They are for a fixed amount;
- This amount will be repaid over a fixed time period, which can be long term;
- There is a schedule of repayments and the repayment amounts will be fixed;
- There can be some repayment flexibility, such as smaller or no repayments over the life of the loan with a large balloon repayment at the end;
- At the end of the loan period, the loan will be repaid;
- Loans can be secured, for example with a debenture over assets, a legal charge over property or chattels and/or corporate or personal guarantees, or can be unsecured;
- Unsecured loans have higher interest rates as, without security of repayment, they are higher risk;
- Loans tend to be larger and longer term than credit facilities, although this can depend on your business type;
- There is a standard application process, which can be lengthy and involve copious documentation;
- There can be a draw-down period during which the loan must be utilised after which any part of the loan not drawn will not be available for drawing.
What are the advantages of a loan?
A loan arrangement has the following advantages:
- A loan has repayment certainty allowing you to budget. This can be important in times of economic uncertainty;
- A loan tends to be for a larger amount and allows you to make investments or acquisitions, which may be critical for your business, even in times of economic uncertainty;
- Loans are typically cheaper than credit facilities with lower interest rates, which can help during periods of instability;
What are the disadvantages of a loan?
A loan arrangement has the following disadvantages:
- A loan is rigid, in being for a fixed sum over a fixed period with a fixed repayment schedule;
- Once the loan has been repaid, it is then unavailable;
- A loan is usually stipulated for a purpose and can only be used for that purpose unless the lender agrees otherwise;
- Penalties can apply for the early repayment of a loan.
What are the key terms of a credit facility?
A credit facility is typically used to support the working and operating capital of a company on a day-to-day basis. Common credit facilities are overdrafts, lines of credit and revolving credit facilities. You may want to use a credit facility, for instance, to bridge gaps between having to pay suppliers and receiving payments from customers.
The basics of a credit facility are as follows:
- A credit facility typically offers you credit up to a maximum amount;
- These funds are available to you ‘on demand’, namely available at any time for an agreed period;
- The amount of credit used will vary as you drawdown funds as needed and then repay when you have surplus funds, repaying as you go;
- Once you make a repayment, the credit is once again available to be used;
- Interest applies to the amount borrowed outstanding at any time and fees also apply for access to the credit facility;
- Credit facilities can be short term or long term, long term giving the greatest flexibility;
- There is usually no stipulation on use of funds beyond ‘working capital’.
What are the advantages of a credit facility?
A credit facility has the following advantages:
- It is flexible, giving you control over your amount of debt, timing of your debt and use of the funds;
- Once set up, it is quicker and simpler to use than arranging a loan each time you need money, important in a crisis, and there are no penalties for early pay off;
- Whilst higher interest rates may apply, these are calculated on a daily basis on the amount actually borrowed and therefore may work out cheaper;
- In times of economic difficulty or for cyclical or seasonal businesses, a credit arrangement can provide a much needed, short term and flexible support to cash flow and working capital.
What are the disadvantages of a credit facility?
A credit facility has the following disadvantages:
- Charges and fees can be high;
- You may have to operate the credit to demonstrate its use as intended (e.g. to support cash flow);
- They can be difficult to secure and require demonstrable trading history.
If you would like to discuss loans or credit facilities in greater detail and understand which might be best for your business, please do no hesitate to contact our corporate law experts.