Short-term loans are used for working capital needs, like buying inventory, marketing expenses, and payroll
The use of funds is tied directly to generating revenue, and can, therefore, be paid back earlier. In other words, you use the loan for a business initiative that generates revenue quickly, which makes the higher interest rate less of an issue.
Long-term loans are used for expansion and growth. Initiatives like remodeling, buying equipment and buying out a partner are excellent reasons to take out a long-term loan. Since the initiatives aren’t directly tied to revenue generation (you aren’t using a long-term loan to fund a paign), they need a longer payback period to soften the blow of larger fixed monthly payments.
Secured and unsecured loans
The whole idea behind collateral is that it becomes a security net for the bank. If you want the bank to lend your business the money, they may require that you, the borrower, pledge a piece of real estate or your assets such as inventory, in order to ensure repayment. If you default on the loan, the bank has the authority to seize the assets or real property in order to repay the debt. When you pledge collateral against a loan, it’s called a secured loan. This means the bank is securing itself from losing out on as little money as possible.
On the other side of the spectrum, you have unsecured loans. Any idea how those are structured? You guessed it again, unsecured loans do not require the borrower to put up collateral. They are heavily based on your personal credit score and slightly based on the relationship history the borrower has with the lender.
Since you’re not providing the lender with any assets or a property-based security blanket, they are considered a bigger risk and we all know that with a bigger risk means a bigger reward, right? So from a lender’s perspective, that bigger reward means a higher interest rate for you, which equals more (bigger) money (reward) for them.
Along the same lines, because you’re not putting up any collateral, you will be required to sign a personal guarantee (PG). A personal guarantee means that you are personally responsible for the repayment of that loan. Not the business, not another stakeholder, nor another partner. If you signed on the PG line, you are responsible for repayment.
Long-term loans are almost always secured, while short-term loans could go either way depending on your credit score, relationship with the bank and if you’re willing to sign a personal guarantee. Lines of credit can also work in this manner where they are either secured or unsecured which brings us to our next point.
Lines of credit
Lines of credit are worth a mention here because they are a version or subcategory of a short-term business loan, but with a slight twist. They’re similar to a credit card in that once the lender approves you for a certain amount, it remains at your disposal. A line of capital is primarily used for working capital needs. They’re great for inventory purchases, operating costs, or they can also be used as general cash flow or capital if you’re in a pinch due to slow sales.
Unlike a loan where you have to reapply once you use up the funds, a line of credit is revolving. This means that if a bank decides to extend a line of credit to you for $30,000 and you take $10,000 to buy more inventory, or invest in marketing to grow sales, you still have $20,000 left to use, or not use. The bank will charge interest on that $10,000 until it’s paid off. When you pay down that $10,000, your credit line goes back to $30,000 without having to reapply like you would for a loan. So, even if you don’t need the cash right away, opening a line of credit sooner rather than later is a smart idea. It’s your security net.