When you run a business, you are likely to encounter situations where you need extra capital. Even when your business is very successful, you may experience a seasonal slowdown of sales, gain a major new project that requires additional funds to get started, or deal with late invoices from large clients. A business line of credit is a common, flexible type of revolving credit that can help you increase your available working capital as needed.
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What is a business line of credit?
A business line of credit is a revolving loan that gives businesses access to a fixed amount of capital that they can withdraw when funds are needed. This can help you obtain borrowed funds quickly. This type of loan is similar to a credit card but differs from a business term loan, which offers a single lump-sum payment that you must pay back over a predetermined period of time.
Businesses can access as much or as little capital as they wish, up to the limit of the credit line. Interest and fees are charged only on the amount of funds you have withdrawn. Because a business line of credit is a revolving account, as you repay your loan, funds become available again.
How does a business line of credit work?
A business line of credit works similarly to a credit card—a business is given a particular credit limit, and the business can borrow up to that limit. Businesses can repay their balances in full, carry balances forward, or pay the minimum amount, with interest charged for any amount borrowed. As a business pays back the borrowed funds, those funds become available to borrow again.
You can receive a business line of credit from a bank, credit union, online lender, or through the SBA. The limits of a business line of credit can be as low as $1,000 or as high as $500,000 or more. Interest rates are typically variable. You may be required to provide collateral or a personal guarantee, especially for larger lines of credit.
Online lenders may approve businesses that would not qualify for a loan from other lenders, but they may charge higher interest rates and fees and offer lower credit limits. Typically, repayment will be on a monthly or weekly schedule.
How can a business line of credit be used?
Business lines of credit are typically used for short-term funding needs, such as temporary gaps in cash flow, payroll, supplies, inventory, hiring new employees, or other operational costs. Business lines of credit can be used for many business purposes. Funds are available as cash that can be transferred into your business’s bank account.
Some common ways that businesses use a line of credit include:
- Making inventory purchases
- Paying suppliers
- Coping with temporary periods of low sales or seasonal slow periods
- Dealing with late invoices or times when you are waiting to receive payment
- Paying for unplanned urgent expenses such as maintenance or repairs
- Hiring new employees to help with increasing business
- Starting a new project or contract
What’s the difference between secured and unsecured business lines of credit?
Secured lines of credit require collateral—assets that the lender could repossess and sell off if the borrower is unable to repay the loan. Assets could be property or equipment, but since the liability for business lines of credit is temporary, collateral for this type of line of credit is more likely to be accounts receivable or inventory.
Secured lines of credit may allow lower interest rates and higher credit limits. This is because the risk of the lender losing money is reduced, as they can sell the collateral to recoup their losses if the borrower defaults. Newer businesses and those with lower credit scores may be able to qualify for a secured line of credit.
Unsecured business lines of credit, in contrast, do not require collateral. Unsecured lines of credit typically have slightly higher interest rates and the maximum line amount may be lower. However, their benefit is that your property would not be at risk if you are unable to repay the loan.
Businesses must have a high credit score and strong financial profile to qualify for an unsecured line of credit; newer and less financially stable businesses would likely not be eligible for this type of loan.
What’s the difference between a business term loan and a business line of credit?
Business term loans are distributed in a single lump sum and have a fixed payment schedule. Interest is charged on the amount as you pay it off, and there are sometimes prepayment penalties if you pay the loan off early. Business loans are typically better suited for large expenses that are paid off over a long period of time, such as building or buying a new location or new machinery.
Business lines of credit differ because they can be accessed multiple times, whenever the need arises. You only take the amount of money you need, and interest is charged on the amount you withdraw. You can generally repay the amount early with no penalty.
What’s the difference between a business credit card and a business line of credit?
Business credit cards can be the quickest way to pay for smaller expenses, as they are easy to use, and you will not have to wait to access your funds. However, they have lower credit limits and may have higher interest rates. In addition, expenses such as lease payments, invoices, and payroll likely cannot be paid with credit cards.
A business line of credit generally offers a higher limit than business credit cards and can provide flexible funding for unexpected expenses or new opportunities. Once you are approved for a business line of credit, you can use it to fund any new projects or keep your business afloat during temporary downturns.
What are the benefits of a business line of credit?
A business line of credit can be useful for businesses in many situations. Here are some of the benefits of a business line of credit:
- Funds are available as needed. With a business line of credit, you can access funds easily whenever a need arises, rather than having to apply and be approved for a new loan. Once you have paid back the amount you used, the funds will be available to you again.
- Lower interest rates. Business lines of credit typically have lower interest rates than business credit cards. However, this depends on the lender, so it’s important to evaluate and compare your options.
- Interest is charged only on the funds you used. When you use a business line of credit, you will be charged interest only on the sum you withdraw. Some banks do charge a commitment fee for business lines of credit. This fee is a small percentage (typically less than one percent) of either the entire limit or the unused portion of the line of credit. In contrast, term loans charge interest on the entire amount of the loan.
- Credit building. Make sure your lender reports to the credit bureaus, as regularly using and paying off a business line of credit can help you improve your business’s credit score. This can make it easier to obtain a term loan or a bigger line of credit later on.
What are the drawbacks of a business line of credit?
Business lines of credit aren’t ideal for every situation. Here are some drawbacks to be aware of when planning to use a business line of credit:
- Complex application process. Business lines of credit require extensive documentation to apply, including business and personal bank statements, tax returns, profit and loss statements, and other documents. The process can be time-consuming.
- Interest rates and fees can be high. Even though interest rates for business lines of credit are typically lower than those of business credit cards, rates can be high. Lenders may enforce fees, so it is important to understand the terms of your line of credit and know what you will be paying.
- Lower limits. Although a business line of credit typically has a higher limit than a business credit card, limits are often lower than term loans. For large investments, a term loan may be wiser.
- Potential for debt and financial difficulties. It’s important to borrow carefully and not overextend yourself, as you could have difficulty repaying large amounts. If you borrow excessively for an undertaking that does not prove successful, you could end up paying a substantial amount of interest with little profit.
- Personal guarantees may be required. It’s common for lenders to require personal guarantees for business lines of credit. If your business is unable to repay the loan, the business owner would be held personally liable and would be responsible for repaying the loan.
What is required to get a business line of credit?
The requirements for a business line of credit vary depending on the lender. Many lenders will require you to have been in business under current ownership for a certain amount of time, such as one or two years. You will need to have good business and personal credit scores—often a score over 600 will be required, but the exact number depends on the bank.
Lenders will require you to provide financial records such as profit and loss statements, bank statements, business and personal tax returns, and other documents. You should be able to show that you have strong revenue and cash flow and will be able to repay the loan. You must have a business bank account. Lenders will also look at available collateral if you are seeking a secured line of credit.
There are a variety of loan options and lenders in the market, and it may be difficult sorting through all of the options. AdvisorSmith analyzed over 30 different lenders and determined the top lenders for small businesses. To determine the best lenders, AdvisorSmith considered a number of factors, including financial strength ratings, customer satisfaction data, complaint ratings from the Better Business Bureau, available terms and loan amounts, and availability of information and ease of use of the lender websites.
|National Business Capital||Overall||National Business Capital is a financing marketplace that specializes in connecting small businesses with a variety of loan products and over 75 lenders.|
|Rapid Finance||Short-term Loans||Rapid Finance is an alternative lender known for offering a variety of short-term loans targeted at small and midsize businesses.|
|Lendio||Startups||Lendio is a financing marketplace that works with a variety of lenders, many of whom offer loans specifically for startups.|
|Fundbox||Lower Credit Scores||Fundbox is an alternative lender that is best known for offering lines of credit and invoice financing for small businesses.|
|Accion Opportunity Fund||Microloans||The Accion Opportunity Fund is a non-profit lender focused on providing funding to small businesses, particularly business owners who are underrepresented minorities and women who may not qualify with other traditional lenders.|
Miriam Torres Baltys is a senior loan officer at CDC Small Business Finance in San Diego, California. She provided the following advice for businesses seeking a line of credit.
When is a business line of credit the best choice for a business?
A business line of credit is the best choice when a business is past the startup phase and permanent capital need phase. A great time to use a business line of credit is when a small business owner has accounts receivables, wholesale prices, or purchase orders that call for a quick turnaround. The time between borrowing and paying the line of credit back should not exceed six months. If it does exceed six months, the lender or bank may choose to convert the business line of credit to a term loan, as a business line of credit is meant to be used for short-term purposes only.
What are common mistakes to avoid when obtaining or using a business line of credit?
Leaving the same outstanding balance for six months or more is a common mistake. You should be drawing from your business line of credit and paying it back within three to six months. You should draw and pay back continuously. Leaving the same balance for longer than six months could give a warning to the lender or bank that this is actually a long-term capital need.
What are the most important things business owners should keep in mind when considering a business line of credit?
Ask yourself, “Will this take longer than six months to pay back? Am I using the money for accounts receivable, purchase orders, or wholesale pricing?” If the cash is needed for longer than six months, consider applying for a term loan.
Do you have any tips for business owners who are looking to get their first business line of credit?
It is important to maintain a trustworthy relationship with your bank or lender so that they are open to lending to you when needed. If you open a business line of credit and then they need to close it or term it out because your balance is outstanding for too long, they may hesitate to give you another business line of credit.
Consider making time to put together some projections or thoroughly think through the “use of proceeds” or what you will be spending your business line of credit on before applying. This will help you decide if you are ready for a business line of credit, or if you may be in need of a long-term loan instead.
A business line of credit is a common, flexible type of revolving loan that can help your business take advantage of opportunities and weather unexpected incidents. Even if your business is very profitable and you do not often experience any cash flow issues, a business line of credit can come in handy. An unexpected opportunity to grow or expand your business may arise, or an unexpected problem may crop up, necessitating extra funds to tide you over while you recover. In these situations, a business line of credit may be the most convenient funding choice.