You can apply for different types of loans. These loans can be secured or unsecured types of loans can come with fixed or variable interest rates. Some loans can come with similar features, others may offer different characteristics. Revolving credits and term loans come with distinguishing features. Individuals and businesses must understand key differences between both types of loans, as that largely affects the perfect utilization of the financing facility.
Let us guide you through the definitions, usage, and features of both types with similarities and differences.
What is a Revolving Loan?
A revolving loan comes with a replenishing feature where the borrower can withdraw amounts and repay to fully utilize the facility again. The lenders approve the term loans once with a maximum credit limit and charge variable interests on them. The revolving loans are approved for the short-term, usually up to one year. The borrower has the option of withdrawing the amount up to the maximum limit. Borrowers do not need to get approval again if they wish to reuse the facility.
What is a Term Loan?
A term loan comes with a confirmed loan amount, period, and repayment schedule. The lenders can charge a fixed or variable interest rate. The borrowers must repay in monthly or quarterly installments. The borrower cannot reuse the facility, once the available credit funds are withdrawn fully. Term loans are issued for the long-term, often ranging from one to twenty-five years.
Characteristics – Revolving Loan Facility Vs Term Loan
Revolving credit facilities offer great flexibility to the borrowers. They can reuse the loan amount by repaying and withdrawing again, the cycle continues for a specified period.
Let us compare the key features with both types of loan facilities.
In a revolving loan, Borrowers can withdraw amounts up to the maximum approved limit. Unlike term loans, they have the flexibility of repaying the minimum payable amount. With each repayment, the revolving credit facility balance replenishes. It allows the borrower to withdraw amounts again. This reuse flexibility is the biggest advantage of a revolving credit facility.
Term loans come with a fixed approved limit backed by collateral. The borrowers have the option of withdrawing the full loan amount at once. However, once they fully withdraw the approved loan amount, they cannot reuse it. The repayments count towards the loan settlement only.
Revolving loans come with variable interest rates usually. The variable interest rate comprises a variable interbank interest plus an agreed premium interest by the lender. Banks consider the revolving loans unsecured, hence charge high variable interest rates for the short-term facility.
Term loans can come with variable and fixed interest rates. Term loans are usually issued for the long-term. Both parties can secure their financial interests with the choice of variable or fixed interest rates. Usually, term loans are offered with fixed interest rates.
There are no fixed monthly repayments in a revolving loan facility. The borrowers need to repay the minimum payable amount only, which is a pre-decided percentage of the total withdrawn amount. However, the borrower would need to repay the full amount once the approved time frame expires.
Term loans on the other hand come with fixed monthly or quarterly repayment schedules. A default on the repayment schedule can result in the loan facility termination by the lender as well. Late payments or non-payments also incur additional penalties and higher interest charges.
The lending bank charges high-interest variable interest rates on an unsecured revolving loan. The approval comes after creditworthiness approval by the lenders. However, the lenders may impose further covenants such as a cash sweep to secure the repayment.
Lenders appraise the borrowers’ creditworthiness keeping in mind the long-term nature of the facility. Banks usually ask for non-depreciating fixed assets as collateral. However, the risky nature of the loan also means banks can impose further covenants to reduce the default risks.
When to Choose the Revolving Loan?
Apart from the interest costs and availability, the key features of a loan can help you decide on the best possible use. A revolving loan offers great flexibility of quick cash access. Hence, the best possible use of a revolving loan should be to fund the working capital needs. You should opt for a revolving loan for short-term needs such as accounts payable, payroll, utilities, and other overheads.
Align the short-term financing needs with short-term loan revolving loans. Since businesses expect cash inflows quickly, they can repay and save on the interest costs.
When to Choose the Term Loan?
Term loans are best suited for long-term investments such as the purchase of fixed assets. These loans should ideally be used for project financing with forecasted cash inflows in the future. Since businesses expect to create value over the long-term with the fixed assets, they should fund these projects with a long-term loan.
Fixed interest rates and a fixed repayment schedule can help a business in financial forecasting and projections. It offers greater stability over the long run.
Pros and Cons of Revolving Loan
Here are some key benefits of using a revolving loan facility.
- It comes with a one-time approval and the borrower can reuse the facility several times.
- It is a flexible solution for short-term financing needs.
- The borrower pays interest only on the withdrawn amounts.
- The borrower needs to repay only the minimum payable with no fixed installments.
- The borrower can repay in full to reduce the interest costs.
Some key Limitations of a Revolving Loan:
- It comes with variable interest rates, that can increase significantly during the approved facility.
- The banks consider it an unsecured form of a loan, hence charge higher interest rates.
- The bank can include several covenants with the facility such as cash sweep.
- The bank can close or reduce the revolving credit limit with an economic downturn.
Pros and Cons of Term Loan
Some key benefits of using a Term Loan:
- It comes with a fixed approved amount with a fixed repayment schedule.
- The borrower has the option of choosing between the variable or fixed interest rates.
- Term loans are long-term financing solutions for fixed asset purchases and long-term projects.
- Term loans come with consistency and stability that can help borrowers in financial forecasting.
Some key Limitations of a Term Loan:
- Borrowers need fixed assets with higher market value to pledge as collateral.
- Borrowers cannot reuse the facility without approval again.
- Borrowers need to make fixed monthly payments, failing to which may result in facility termination.
- Late payments incur higher interest and penalties.
Revolving loans offer the flexibility of easy repayments and reuse. Term loans offer the consistency of fixed repayments and scheduling. Both types of loans can offer fixed and variable interest rates. Revolving loans are more suitable for short-term financing needs such as working capital, while term loans are suitable for long-term fixed asset investments.