A business line of credit can serve as a safety net for businesses when unexpected expenses arise.
- A line of credit can help you cover unexpected financial needs and support long-term business growth.
- A line of credit provides you with a revolving amount of money that you can draw upon when needed.
- A line of credit is a good tool to help build your business credit.
- This article is for business owners who want to learn more about using a line of credit as a source of financing.
A common unwritten business rule is that it's better to have access to financing before you need it. If you wait until your business is in a desperate financial situation to apply for a loan, you may not get the funding you need in time. That's why taking out a line of credit could be a smart move for some businesses.
A line of credit gives you access to the financing you need before you need it, but you only have to repay the amount you actually spend. It serves as something of an insurance policy in the event of any unexpected financial challenges or growth opportunities that require additional capital. However, before jumping at this type of financing, it is important to understand the pros and cons so you can decide whether this financing option is right for you.
What is a business line of credit?
A business line of credit gives you access to a predetermined amount of money that you can borrow from on an as-needed basis. Instead of receiving an upfront lump sum, you have access to a revolving line of credit.
It's similar to a credit card, but a business line of credit tends to come with much higher credit limits. As with a credit card, you can use it to make cash withdrawals or transfer funds to your business checking account.
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A business line of credit is ideal for short-term operating expenses, like payroll or inventory. You can take out as much money as you need, assuming it doesn't surpass your credit limit. Then, you can either pay off the remaining balance or make minimum monthly payments.
The nice thing about a business line of credit is that you'll only pay interest on the money you spend. For instance, if you have a $50,000 line of credit but only use $10,000, you'll only pay interest on the $10,000.
Key takeaway: A business line of credit provides business owners with access to a revolving line of capital when they need it. The borrower only pays interest on the amount spent, and when they repay the money, they can access the line of credit again.
What is the difference between a line of credit and a term loan?
A business line of credit and short-term loans are similar in that both give you access to working capital for your business. These two financial products just go about it in different ways.
With a short-term loan, you'll receive a one-time lump sum of money. When you qualify for the loan, you agree to repay the principal with interest over a set period. Business loans follow a fixed repayment schedule, and you'll know how much you must pay every month.
Business loans are a good option to fund a large, planned expense. For instance, if you're looking to invest in a marketing campaign or purchase new equipment, a term loan may be a good choice.
A line of credit, meanwhile, allows you to access a certain amount, but you don't receive the funds all at once. You draw from your line of credit on an ongoing basis, and there are no set repayment terms.
When should you use a business line of credit?
A business line of credit is ideal for companies that are looking for flexible financing options. You have ongoing working capital needs and want to have the cash flow available to cover business expenses as they arise.
For many businesses, cash flow varies monthly, and there may be discrepancies between the amount coming in and the amount going out. And expenses often come up that are hard to plan for.
A business line of credit gives you access to the funding you need, typically with lower interest rates than what you'd pay for a credit card. It can help you cover a variety of expenses, such as these:
- Quarterly tax payments
- Past-due invoices
- Seasonal lulls in your business
- Operating expenses
- New hires
What is the difference between a secure and unsecured line of credit?
The line of credit you receive will either be a secured or unsecured loan. A secured line of credit requires some type of collateral. For instance, you could use property or equipment to secure the line of credit. Banks and credit unions commonly give out secured lines of credit. This collateral gives the bank more security because, if you default on the line of credit, it can collect on the collateral.
An unsecured line of credit doesn't require any collateral. This is ideal for most business owners, because you're not putting your business or personal assets at risk.
Did you know? While unsecured loans may seem ideal, be aware that they likely come with higher interest rates to offset the risk to your lender.
Pros and cons of a business line of credit
Like most financing options, business lines of credit have both benefits and drawbacks. Knowing both will help you understand if this is a good option for your business.
- It's a flexible financing option. One of the biggest draws for many businesses is the flexibility a line of credit provides. You have access to a certain amount of money and can draw from it on an as-needed basis. Once you pay back the funds, you're free to spend the money again.
- It can improve cash flow. Cash flow is a problem for many businesses, especially if you have a seasonal business or clients who take a long time to pay. A line of credit can give you the funding you need for ongoing business expenses, and then you can pay it back once you have the funds.
- You only pay interest on what you spend. With a line of credit, you only have to pay for the amount you spend. So, if you only end up spending a fraction of your line of credit, you'll pay less interest overall.
- It's a better option than a credit card (usually). A business line of credit operates in the same way as a credit card, but they aren't the same. A business line of credit tends to have a higher credit limit, and you'll often receive a lower APR. Plus, you can use a line of credit for things like payroll, which may not be an option with a credit card.
- It can help you build business credit. Your lender will report your payments to the three major credit bureaus, so a line of credit can help you build your business credit if you regularly pay on time. This can be helpful if you want to apply for a small business loan in the future.
- It has higher rates and fees. A line of credit is less expensive than using a credit card, but it is more costly than taking out a small business loan. You could get stuck with withdrawal and maintenance fees and, depending on your credit, a high APR. You should work with your lender to negotiate these fees.
- It can be challenging to qualify for. Depending on where you apply, it can be challenging to qualify for a business line of credit. In particular, banks and credit unions tend to have a stringent qualification process and may require you to put down collateral. You should expect to provide comprehensive financial statements during the application process. [Read related article: 8 Factors That Keep You From Getting a Small Business Loan]
- It must be managed carefully. A business line of credit can be great for covering short-term cash flow needs. As you would any type of debt, though, you must manage it carefully. It's easy to find yourself trapped in a cycle of debt that keeps building on itself if you don't stay on top of your payments from the start.
How to qualify for a line of credit
If you're looking for a flexible financing solution to manage ongoing cash flow needs, applying for a business line of credit could be the right move. However, the application process can be demanding, requiring you to share a lot of personal and business information.
Tip: Compare all your options during the application process. Using a lending marketplace is a good idea because it allows you to submit one application and receive quotes from multiple lenders.
[Check out all of our reviews of the best business lenders.]
Some of the requirements will depend on the business lender you choose, but here are a few of the things you need to qualify for a business line of credit:
- Credit history: One of the first things your lender will want to see is your personal and business credit score. This information helps your lender evaluate how likely you are to repay the loan. A credit score over 700 will help you qualify for the best rates and terms.
- Revenue and cash flow: Your lender will also want to see that your business brings in solid and steady cash flow. They're looking for signs of stable and consistent growth over time. You can expect to provide bank statements, your business tax returns, profit and loss statements, and your financial projections.
- Business history: Most lenders want to see that you've been in business for at least two years. If you're a newer business, that doesn't automatically disqualify you from funding, but you may have to put down collateral.