What Is a Business Line of Credit & How Does it Work?

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    Lack of capital is a leading reason many small businesses fail in their first year or soon after. Fortunately, the right business financing option can help your startup survive cash flow hiccups. A business line of credit is the ideal solution.

    What is a business line of credit, and why should you consider it as a financing option? Read on to find out.

    What Is a Business Line of Credit?

    A business line of credit is a revolving financing option you can draw from whenever you need money for business expenses. However, a line of credit has a fixed limit for the amount of money you can withdraw.

    Once you get a line of credit, you can make multiple withdrawals until you reach the limit. There will be a stipulated repayment period which you should honor to avoid higher interest or having your line terminated.

    Types of Business Lines of Credit

    There are two main types of credit business lines: secured and unsecured credit lines.

    Secured Line of Credit

    A secured line of credit is where the lender requires collateral to approve your loan request. Collateral can be assets such as property, business inventory, or accounts receivable.

    Most lines of credits offering higher amounts of money are usually secured. Many lenders are reluctant to give unsecured loans to newer businesses, so keep this in mind when applying for a line of credit.

    Unsecured Line of Credit

    An unsecured business line of credit is when you don’t need to give any collateral to qualify for a loan. Instead, your lender will need proof of good personal and business credit rating and financial statements showing annual revenue and profits to help them gauge risk.

    Also, they’ll impose higher interest rates on an unsecured line of credit than on a secured one. An unsecured business line will typically offer lower credit limits than secured types.

    Requirements for a Business Line of Credit

    Before a lender can consider you for a line of credit, they’ll need to access your business to determine your risk.

    Many of the requirements for a business line of credit go towards proving your business’s financial health and your ability to make payments. How well you meet the requirements will determine the limit your lender gives you.

    Here are some of the things lenders check before approving credit requests.

    Financial Statements and Reports

    About 50% of startups fail in the first five years of operation. Hence, creditors need financial statements and tax reports to decide whether to give you a line of credit. With these, they can determine whether you’re generating enough revenue to support your line of credit payments.

    Operating Time

    Most lenders require you to have been in business for at least a year to consider you for a line of credit. Large banks will often only approve you if you’ve been in operation for at least two years.

    Being in operation for a more extended period with sound financial health is proof that your business is making good revenue, which presents less risk to the creditor.

    When you’ve not been in business for very long, you may have difficulty accessing a line of credit. If a lender does approve you, they’ll probably impose a high-interest rate and require collateral.

    Credit Score

    Some lenders have a set minimum credit score that small business owners must meet before they can approve requests for a small business line of credit. The higher the amount of credit you want, the higher the minimum credit score you’ll need to meet.

    Note that lenders will need to see your business credit score besides your individual one, so open a business bank account to start building your score.

    If you have a poor personal or business credit score, you might want to check out the best bad credit business loans available today.

    Collateral

    To get a secured business line of credit, you’ll need to provide collateral. Collateral could be anything from business assets to real estate equity. Banks are more likely to give you lines of credit if you can provide qualifying collateral.

    Personal Guarantee

    What happens if you cannot pay back your used credit amount? Your bank may require you to provide a personal guarantee as the business owner. A personal guarantee allows them to hold you individually responsible if you cannot repay the small business loan. In such a case, they may take your personal assets as collateral.

    When Should You Get a Business Line of Credit?

    Different types of small business loans come in handy when your business fails to generate enough capital. However, it’s best not to wait until you’re in financial trouble to apply for a business line of credit.

    The best time to get a credit business line is when your business is doing well.

    One reason is that when your company has good financial health, lenders will be willing to lend you higher amounts at lower interests.

    Secondly, applying for a line of credit can take time, which is inconvenient when you need immediate funding. Having a line of credit on standby means that you can access it immediately when you need money.

    Reasons To Get a Business Line of Credit

    As a small business owner, you’ll need funding at different times for various reasons. To keep from getting into debt trouble, it’s crucial to get the right loan for the correct purpose. A business line of credit could be your best option to:

    • Get working capital.
    • Buy new equipment.
    • Acquire extra inventory for a busy season.
    • Hire new staff.
    • Take advantage of time-limited opportunities.

    To Get Working Capital

    Many startups lack working capital for daily business expenses for reasons such as delayed payments by clients or seasonal cash flow gaps. Both are temporary setbacks that you should not allow to run your business into the ground.

    A business credit loan can provide you with the working capital you need while waiting for clients to fulfill your accounts receivables or for sales to pick up again. Since both scenarios may be repetitive over the years, a line of credit with a fixed amount you can draw from regularly is more suitable than a term loan that only gives you a lump sum amount once.

    New Equipment Purchase

    As your business grows, you may need to buy new equipment to expand operations and meet rising demand. Having a line of credit available to you allows you to draw funds to buy the new equipment immediately.

    Acquiring Extra Inventory for a Busier Season

    Various industries have business seasons with higher demand than the rest of the year. You’ll need extra inventory to take maximum advantage of the increased activity when this time comes.

    Since this increases your expenses, it might be challenging to pay for the new inventory with your usual cash flow. Drawing from a line of credit comes in handy at such a time.

    Also, due to the guaranteed higher returns from a busier season, you’re more assured of making enough profits to pay back your drawn amount in the provided repayment period.

    Hiring New Staff

    Sometimes, hiring new staff is necessary to keep up with a growing business. Before your revenue can support the added payroll expense, a business line of credit will help you successfully manage cash flow shortage.

    To Seize Time-Limited Business Opportunities

    It’s possible to receive an opportunity to grow your business, such as acquiring a new high-paying client, when you don’t have enough resources to deliver the required services. Getting a line of credit allows you to cover any capital shortage to take on new opportunities and grow your business.

    How Can You Benefit From a Business Line of Credit?

    Having a line of credit brings many benefits to your small business, including:

    • Flexibility.
    • Lower costs.
    • Accessibility.
    • Credit score improvement.

    Flexibility

    Flexibility is the most significant benefit small business owners get from business lines of credit. A line of credit allows you to withdraw funds multiple times as long as you don’t exceed the total credit limit and pay back the cash you’ve used.

    You also don’t need to apply for access each time you need money. All you have to do is withdraw cash, then ensure to repay it within the provided repayment window. In a way, it’s similar to having a savings account you can access at any time.

    Lower Costs

    Generally, business lines of credit are less costly than a traditional small business term loan. First, you’ll be paying interest only for the amount of money you withdraw. For instance, if you draw $30,000 from a business line of credit with a $50,000 limit, you’ll only be required to pay interest on the $30,000 you’ve used.

    Second, most lines of credit don’t have early repayment penalties compared to traditional loans. This allows you to pay back used funds as soon as possible without worrying about penalties and get access to more cash.

    However, note that the costs associated with your credit line mainly depend on the lender you use. Costs you may need to cover include origination fees on application, a monthly maintenance fee, inactivity, and draw fees. When looking for a line of credit, consider one that doesn’t have a lot of charges.

    Another important thing to remember is that your credit line costs will increase sharply if you’re late for payment or withdraw beyond the agreed credit limit. To avoid these scenarios, apply for a line of credit that gives you an ample limit and only withdraw funds you can repay within the provided payment period.

    Accessibility

    For many businesses with bad credit, a credit line is easier to access than a traditional term loan. This is partly because you can get the lowest limits with a line of credit, and some lenders will be willing to give you one if your cash flow is healthy despite having bad credit.

    Credit Score Improvement

    Many small businesses struggle paying monthly payments on high-interest loans that they receive as a lump sum, affecting their credit scores. A line of credit allows you the flexibility to withdraw small amounts of cash you can pay quickly, multiple times, which works to build business credit score.

    Pros & Cons of Business Line of Credit

    Like every other business loan, a small business line of credit has pros and cons. When seeking a credit loan, it’s vital to weigh both the advantages and disadvantages to determine whether it’s the best option for you.

    Pros

    • Lower interest rates than other business loans.
    • Provides revolving credit; no need for repeat applications.
    • An excellent way to build your business credit score.
    • Suitable for businesses with bad credit.

    Cons

    • May require collateral for approval.
    • Some lenders require updated financial statements after each draw.

    Where Can You Get a Business Line of Credit?

    You can get a credit line from major banks, credit unions, community banks, commercial banks, or online lenders. Traditional banks typically offer higher limits but have more stringent requirements.

    You’re more likely to find a lower limit line of credit from smaller banks, credit unions, or online banks. Also, most traditional lenders are reluctant to give unsecured business lines, while other lenders readily approve credit without collateral.

    An online lender is an excellent option if you’re looking for unsecured lines with less stringent requirements. Fundbox is one of the most trusted online lenders you can consider, and it offers lines of credit up to $150,000. Its requirements include 6+ months in business and a 600+personal FICO score.

    When choosing lenders, it will help to consider SBA-approved institutions. Lenders are more likely to give you higher limit credit through the Small Business Administration (SBA) because it’s guaranteed by the government.

    What’s the Difference Between Business Lines of Credit & Business Credit Cards?

    It’s easy to confuse a business line of credit with a business credit card because they’re both revolving loan options. However, several differences distinguish the two.

    First of all, business lines of credit give you cheaper access to cash, while withdrawing cash from a credit card comes with hefty fees. Business credit cards are more suitable for paying for purchases electronically. On the other hand, a line of credit is more economical for withdrawing cash to use for various purposes.

    Secondly, business credit cards carry higher interest rates than lines of credit. A business credit card will also have higher maintenance fees than a line of credit.

    Frequently Asked Questions (FAQs) for Business Line of Credit

    Final Thoughts on Business Line of Credit

    A business line of credit is one of the most flexible financing options you can get to help you bridge cash flow gaps. It also allows you to seize growth opportunities, translating to better revenue generation in the future. When looking for a business credit line, go for a lender with the most favorable conditions to your company.