What's the difference between a line of credit and a loan?

You’re considering financing for your firm, but where do you start? It’s first important to identify what type of funding will best work for you. Start with the basics—what’s the difference between taking out a loan and obtaining a line of credit?

One of the biggest distinctions between a loan and a line of credit is how you acquire the funds. A loan is typically delivered in a one-time lump sum. Most often, loans are taken out to complete large purchases that would otherwise not be affordable or to consolidate pre-existing debt.

A line of credit functions much like a credit card—you are given a maximum threshold from which to draw upon at your digression, and in varying amounts. Lines of credit are best suited for situations where your anticipated legal fees fluctuate or generally when your income and costs don’t match up because it gives you a dependable source of capital.

Another difference between a loan and line of credit is how interest is calculated.

With a loan, interest begins to accrue immediately upon receipt of the funds. Many times the interest rate is on the lower end of most financing options and is typically a fixed percentage.

Credit lines, in contrast, only charge interest on the actual amount borrowed rather than the full capacity of the line. For example, you may qualify for a $1 million line of credit, however if you only draw $250,000 on the line, you will just be charged interest on that amount. Interest rates tend to be higher for lines of credit than loans and may be at variable rates 

Loans also differ from lines of credit in terms of repayment.

Loans are generally repaid in fixed installments over a specific period of time. Moreover, loans have a maturity date, or specific end, and the periodic payments are calculated to reflect the interest accrued and principal amount to be repaid within that timeframe.

The repayment of a line of credit is based only upon when the funds are borrowed and not the maximum limit of the line. Because of the flexibility of a line of credit, payments are typically not made on a pre-determined schedule. You can draw from the line when you need and pay down the balance immediately in order to restore your borrowing capacity or repay the line in set installments like you would a loan.

In addition, lines of credit normally do not have a rigid end date—rather they may be open-ended or have a renewal option built into the terms.

Whether you’re considering a line of credit or a loan, you should plan to get your credit in a good place and take a hard look at how you plan to use the funds. Your bank is always a good place to start when evaluating your options. Conversely, contingent-fee law practices are unique—a specialty law firm lender may be better equipped to fully understand your needs and provide a financial solution tailored to your firm.

The following article is part of a collaborative educational blog series, Finance Corner: A Guide for Plaintiffs' Attorneys and their Clients. If you are interested in receiving similar articles, you can subscribe here.