You might have heard about the term revolving and non-revolving business loan before but do you know the difference between the two?
Under which circumstances should you choose one over the other? Let’s take a look at the difference between these two types of SME financing facilites and which you should choose.
Revolving line of credit
A revolving line of credit is used to categorize a credit facility which does not have a fixed term. This means that you can tap onto the credit facility over and over again.
Revolving line of credit can be both secured or unsecured. If it’s secured, the banks or financial institution has a collateral that you placed on lien for the credit line they have extended to your company.
Usually, secured line of credit’s interest would be lower than unsecured as the financier has lower risk with the collateral you pledged. Also, the credit limit could be higher as it can be based on the valuation of your collateral pledged.
For example, if you have a fully paid property of $1M valuation pledged to the bank for credit line, the bank could potentially grant up to 70% to 80% of the property’s valuation as credit line facility.
It would be tougher for a small business to get a totally unsecured credit line of $700K-$800k though.
When bankers use the term “revolving”, it essentially means that you can utilize repeatedly the credit line up to the limit granted to you. It works similar like your personal credit card.
Let’s say your company have an unsecured credit line of $100K and you’ve already used $50K. You can still access the remaining limit of $50k anytime.
When you pay back the outstanding $50k, your credit limit goes back up to $100K again and you can continue tapping on the line as and when required.
In the SME loan Singapore context, revolving credit line financing facility offered by banks are usually either overdraft or trade finance line.
Overdraft is a plan vanilla simple facility where you can withdraw cash on demand up to your credit limit granted.
Trade financing line is slightly more complicated. It still bears a credit limit like overdraft but limit is usually higher.
Also, the key difference is you can’t withdraw cash or make cheque payments from a trade financing line, unlike overdraft accounts.
You can only utilize the trade finance line to make payments to your suppliers by presenting your supplier’s invoice to the bank.
Transportation documents such as delivery order or bills of lading might be required as well if you request for your banks to make immediate payment transfer to supplier.
Almost all trade financing line will come with LC (Letter of Credit) facility which allows you option for instructing your bank to issue LC to supplier.
This is more commonly used when making overseas purchases from foreign suppliers. The LC you issued will subsequently be converted into TR (Trust Receipt) which amount will count against the initial credit limit granted on the trade financing line.
Non-revolving credit facility
When the term “non-revolving” is used, it basically means the credit facility is granted on one-off basis and disbursed fully. The borrower will then make installment payments back against the principal loan.
The most common form of non-revolving credit facility would be the unsecured business term loan.
If your business loan application is approved, you’ll receive disbursement in a lump sum which will be the principal loan amount. You’ll pay it back over a specific term ranging from 1 year to 5 years.
Another type of non-revolving facility is secured term loan. You’ll not receive any cash but it’s meant to fund your company’s purchase of an asset, typically a commercial or industrial property.
Your bank will pay directly to the asset’s seller the purchase price, including your portion of the down payment (typically 20%-30% for property purchase). You’ll then make monthly installment on the loan amount over 10-25 years period.
Unlike revolving lines of credit that are typically reviewed by the banks every 1 to 2 years, a term loan is fixed for the specified term of repayment.
Most term loans in Singapore are calculated on reducing balance monthly rest basis. Your original loan principal loan amount will be amortized throughout the term of the loan.
Unlike a revolving credit line, you’ll need to re-apply for a fresh loan if you require more funds, after the funds for the first loan is disbursed to you.
Typically, most banks will also levy an early repayment penalty if you redeem the loan partially or in full before the loan tenure is finished.
Some banks call this a “break-fund” cost. The early repayment penalty ranges between 1-5% of the outstanding amount redeemed. Some banks might charge the penalty based on the original loan amount instead.
As most term loans are amortized, it might not be cost effective to redeem loan especially during the later stage of the loan term. The redemption penalty could be higher than the interest portion of the loan during the tail end of the loan tenure.
Which type of SME finance facility should I choose?
This depends on your circumstance and more importantly, your financing requirements.
If you need financing for mid to long term, for example purchasing equipment, you should opt for a non-revolving term loan facility.
Acquiring other companies, purchasing property or any other business purpose that you foresee will take you 1-3 years to materialize ROI are situations where you should utilize term loan.
Another example where a non-revolving term loan should be utilized:
You are expanding to another outlet or setting up new branch and require funding for office set-up, hiring additional manpower, renovation etc. As the ROI from the expansion will only trickle in at least 1 year later, the appropriate financing type should be non-revolving term loan.
A revolving credit line on the other hand should be matched to short term financing needs.
Many SME owners use it as a ‘standby facility” as it can help deal with very short term working capital emergencies.
It’s a useful financing tool to plug any cash flow gaps temporarily and smooth out working capital cycle.
However, it is important to understand that revolving credit line such as overdraft are calculated very differently from term loan which is amortized.
Overdraft is usually calculated on accrued interest at daily or weekly compounding basis.
Compounding interest is the opposite of amortized interest and financing costs will be prohibitive if used the wrong way.
If you utilize overdraft like a term loan any intend to pay back the utilized amount over long term of say 1 year, the compound interest will soon snowball and balloon up to a large sum relative to the original amount utilized.
Use the overdraft only for short term financing situations such as funding payroll, expenses seasonal in nature or bridging cash flow gap when trading products.
The key point to make here when deciding between revolving and non-revolving facility is to match your funding needs time line to the appropriate facility.
Short term funding needs = Revolving facility
Mid-long term funding needs = Non-revolving facility