commercial loans vs. business line of credit

October 22, 2021

Mike Luster and Andrew Marques from Cape Ann Savings Bank talk about the differences between commercial loans and business lines of credit.

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Transcription Disclosure: Below is a transcript of the conversation between John Maher, Mike Luster and Andrew Marques. Please note, this is an unedited "word for word" rendition of the actual conversation and is not intended to be grammatically correct.

John Maher: Hi, I'm John Maher and I'm here today with Mike Luster, executive VP and commercial loan officer and Andrew Marques, commercial loan officer at Cape Ann Savings Bank. Today, we're talking about commercial loans versus business lines of credit. Mike and Andrew, welcome.

Mike Luster: Thanks, John. Happy to be here.

Andrew Marques: Hey John, thanks for having us.

What Is a Commercial Loan?

John: Sure. So what is a commercial loan, first of all?

Mike: Commercial loans can be used for many things. A commercial loan can be a commercial real estate loan to buy real estate. A commercial loan could be a commercial installment or a term loan, which is used to buy equipment, inventory, vehicles, you name it… anything that a business can use as an asset. If they need to finance it and they don't necessarily want to drain their cash to buy it, they would apply for a commercial loan to do it. Items like a drill press, a lathe, a forklift, a pickup truck, a dump truck, anything like that would be financed through a commercial installment loan. Commercial real estate loans, like we talked about in an earlier podcast, are used to buy real estate.

Another use of a commercial loan, John, is sometimes there's a family business out there, they want to transition or make a succession plan to pass the business to the kids or another member. The kids don't necessarily have the cash to do it. They need to take out a commercial installment loan to do it. So they would talk to us about that. So any type of equipment purchase or even the transition of a business, one party to another, would need some sort of commercial loan.

What is a Business Line of Credit?

John: Okay. And then what is a business line of credit? How does that differ?

Andrew: A business line of credit is typically structured on a revolving basis, meaning you draw the line up and pay it down as cash flow allows. It's typically tied to a business' balance sheet and their business cycle. So it's used to even out cash flow of a business where they might earn a lot of income all at once, whether it's due to seasonality or a longer business cycle or if they have multiple receivables in place.

We can structure the business lines of credit, depending on the needs of each individual business. Sometimes we tie it to accounts receivable, inventory and cash on hand. Sometimes it's tied to the seasonality of a business where we require 30, 60, or 90 days of what we call a cleanup period. That means the line is revolved down to zero. It remains at zero for that period of time. So really we're looking at a line of credit for short term needs where a business loan might be a term loan or a mortgage has a much more permanent need and has a longer cycle of that capital usage.

Business Line of Credit Usage Patterns

John: Did you say with that business line of credit that you'd like to see companies use that business line of credit and then pay it off completely and then have no line of credit for several months before they maybe take out another line of credit? Is that what you're saying?

Andrew: Typically there would be one line and you can make advances on it as the money is needed. You may draw 10% of that line, use that funds in your business operation. Then, you might need another 10%. So you're up to 20% of the line of credit. You can pay it down by 5%. And so as the business cycle fluctuates, as cash flow fluctuates, the availability and the balance on that line of credit might fluctuate.

The nice thing with lines of credit, you pay interest only on the funds you borrowed, but there is expectation to pay it down. So it's up to the businesses to really stay on top of their cash flow, to cycle that balance down and keep it in line with their operations and their cash requirements.

We never like to see a line of credit go, what we call evergreen, meaning it never cycles. It never goes down. The balance stays the same. And that really is a reflection of incorrect use of the funds. Maybe they bought a piece of equipment, machinery, a vehicle with those funds and it hasn't been utilized the right way where they could cycle down that balance as they're earning cash flow into business itself.

Business Line of Credit Versus Personal Line of Credit

John: Can I think of a business line of credit as being a little bit more like a person just getting a credit card? Where maybe you have a $20,000 limit on your credit card, but you're not necessarily going to immediately go out and buy something for $20,000. You're going to buy something for a few hundred dollars and then buy something else for another few hundred dollars. And now you have $600 on that credit card and you have to kind of pay that off, maybe all at once or maybe over a few months or something like that. And then maybe you make another couple of purchases. So is it sort of related to that?

Andrew: Absolutely. Yeah. A credit card really is a personal line of credit. It should be looked at the same exact way.

When Should Businesses Use Each of These Types of Credit?

John: In what situations do you really use a commercial loan versus a business line of credit and how do you help a business to understand which one they should use for certain types of purchases?

Mike: Well, John, it's about starting a conversation with the borrower and figuring out what the use is. You want to match the loan type with the asset that it's being used for. So a customer says, "I want to buy a forklift or a dump truck." That's not something that would go on a line of credit because that's something that should be amortized out over a longer period of time. You'd want to use a commercial loan in that instance, maybe over three, four or five years.

Any type of vehicle, machinery, or equipment is something that's going to be more of a term asset. In a term of the loan, the amortization should match the depreciation schedule on the vehicle, essentially. So that's what we try to do. As far as a business line of credit, Andrew explained it perfectly, it's short term. Even as you mentioned, John, it's like a credit card.

We want it to revolve. We want you to use it, pay it back, use it again. So it's always there when you have that need for short term borrowing to purchase inventory, to maybe add someone to your payroll for that period. Even to get started up for a landscaper for the season, anything like that, just for that short term purpose, where it's ultimately going to get paid off with the collection of a receivable, that's more of a short term need. It's really about matching the type of the loan with the asset it's being used for. And that's what we try to do through constant communication with our customers.

What Type of Loan or Credit Do Businesses Use the Most?

John: Right. Okay. And so is one type of borrowing better than the other for businesses or do most businesses really utilize both?

Andrew: It can be both. It can be one or the other. It really depends on the business' operations and what their borrowing needs. Some businesses have a really short business cycle where they are able to recognize their revenue almost immediately. If you think anytime you're collecting funds on a credit card, that settlement happens each night, this is often the case for retail businesses.

Service businesses sometimes have longer terms, so they might need a line of credit to, again, even out that business cycle, its fluctuations and its cash flow needs and surpluses. It really comes down to the operations of a business, the purpose of the borrowing and the funds needed. We often see businesses that will have multiple term loans for different pieces of equipment and an operating line of credit that they use for their short term needs. So they're using the long term capital expenses and the term loan that they're able to pay down to zero over maybe five years. And they're also able to revolve a line of credit for those short term cash flow needs.

Contact Cape Ann Savings Bank to Talk About Your Commercial Lending Needs

John: All right. Well, that's really great information, Mike and Andrew, thanks again for speaking with me today.

Mike: Thanks, John.

Andrew: Good to talk.

John: And for more information on commercial lending, visit the website at Capeannsavings.bank.

Cape Ann Savings Bank, member FDIC, member DIF, equal housing lender.