A common unwritten business rule is that it’s best to access 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. [Read related article: Small Business Financing Options That Bypass Traditional Banks]
A line of credit gives you access to the financing you need before you need it, and you have to repay only 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’s essential to understand its pros and cons to determine whether this option is right for you.
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What is a business line of credit?
A business line of credit is a type of business loan that gives you access to a predetermined amount of money you can borrow on an as-needed basis. Instead of receiving an upfront lump sum, you can access a revolving line of credit.
A line of credit is similar to a business credit card, but with a much higher credit limit. As with a credit card, you can use it to make cash withdrawals or transfer funds to your business checking account.
A business line of credit is ideal for short-term operating expenses such as 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 pay interest only on the money you spend. For instance, if you have a $50,000 line of credit but only use $10,000, you’ll pay interest only on the $10,000.
A business line of credit is a small business financial management tool that lets business owners access a revolving line of capital. The borrower pays interest only on the amount spent; when they repay the money, they can access the line of credit again.
When should you use a business line of credit?
A business line of credit is ideal for companies seeking flexible financing options. It’s a great choice if you have ongoing working capital needs and want appropriate cash flow available to cover 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. Additionally, expenses often arise 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 various expenses, including the following:
- Quarterly tax payments
- Past-due invoices
- Seasonal lulls in your business
- Operating expenses
- New hires
- Equipment
How to qualify for a line of credit
If you’re looking for a flexible financing solution to help manage cash flow, applying for a business line of credit could be the right move. However, the application process can be demanding, requiring you to share significant personal and business information.
While some requirements will depend on the business loan you choose, you’ll likely have to provide the following:
- 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 a solid and steady cash flow. Lenders look for signs of stable and consistent business growth over time. You can expect to provide bank statements, business tax returns, profit and loss statements, and financial projections.
- Business history: Most lenders want to see that you’ve been in business for at least two years. Newer businesses aren’t automatically disqualified, but you may have to put down some type of collateral.
Compare your lending options and evaluate all loan contract terms. Consider using a lending marketplace so that you can submit one application and receive quotes from multiple lenders.
Pros and cons of a business line of credit
Like most financing options, a business line of credit has benefits and drawbacks. Knowing both will help you understand if this is a good option for your business.
Pros
- A business line of credit is a flexible financing option. One of the biggest draws for many businesses is the flexibility a line of credit provides. You can access a specific amount of money and draw from it as needed. Once you repay the funds, you’re free to spend the money again.
- A business line of credit 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 you can pay it back once you have the funds.
- You pay interest only on what you spend. With a line of credit, you have to pay for only the amount you spend. So, if you end up spending only a fraction of your line of credit, you’ll pay less interest overall.
- A business line of credit is a better option than a credit card (usually). A business line of credit operates somewhat like 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 annual percentage rate (APR). Plus, you can use a line of credit for things like payroll, which may not be an option with a credit card.
- A business line of credit 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 business credit if you regularly pay on time. This can be helpful if you want to get a bank loan in the future.
Cons
- A business line of credit has higher rates and fees. A line of credit is less expensive than using a credit card but 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.
- It can be challenging to qualify for a business line of credit. Depending on where you apply, qualifying for a business line of credit can be challenging. In particular, banks and credit unions tend to have a stringent qualification process and may require you to put down collateral. As mentioned, 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]
- A business line of credit must be managed carefully. A business line of credit can be great for covering short-term cash flow needs. However, as with any debt, 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.
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 business loan.
- Secured line of credit: A secured line of credit requires some type of collateral, such as property or equipment. Banks and credit unions commonly offer secured lines of credit. The collateral gives the bank more security because if you default on the line of credit, it can collect on the collateral. [Read related article: What Do You Need to Open a Business Bank Account?]
- Unsecured line of credit: Unlike asset-based lending, an unsecured line of credit doesn’t require collateral. Most business owners prefer unsecured lines of credit because they don’t have to put their business or personal assets at risk. Still, while unsecured loans may seem ideal, they may come with higher interest rates to offset your lender’s risk.
What is the difference between a line of credit and a term loan?
A business line of credit and a short-term loan are similar because 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. 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 specific 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.
The best business loan providers for lines of credit
Among our picks for the best business loan providers, these vendors offer high-quality lines of credit:
- Fundbox: Fundbox helps business owners make informed decisions by providing all loan costs and terms upfront. This lender offers lines of credit up to $150,000 with repayment terms of 12 or 24 weeks. Our review of Fundbox explains its easy repayment program with weekly installments.
- SBG Funding: You can obtain a line of credit as large as $750,000 with SBG Funding. You’ll typically hear back on approval from this lender within 24 hours, and your rate could be as low as 1 percent per month. Explore this lender’s offerings via our SBG Funding review.
- Rapid Finance: When you secure a line of credit through Rapid Finance, you can set up automatic monthly, weekly or daily payments. Your repayment term will range from three to 18 months and may reset with every draw you take. Learn more about this lender via our Rapid Finance review.
- Noble Funding: Unlike typical lines of credit, Noble Funding’s offering is based on the value of your accounts receivable (A/R). This structure resembles invoice factoring but without the rate increases that continuously occur if your clients fail to pay their invoices. Check out our Noble Funding review to learn more.
- BusinessLoans.com: This vendor isn’t a lender; rather, it’s a marketplace that will connect you with lenders that offer lines of credit that suit your needs. You can find numerous resources on this brand’s website to educate yourself about lines of credit as you await connection with a loan partner. Discover what else you can get through this lending website via our BusinessLoans.com review.
Give yourself credit where it’s due
Setting up a business line of credit can give you a financial fallback well in advance of any actual need. It’s also a great way to improve your business credit, assuming you pay your draws back in a timely fashion. Obtain the right line of credit, and you’re well on your way to funding your business, with so much less of the usual risk.
Jamie Johnson contributed to this article.
