How Does a Line of Credit Work and When is It Useful?

When running a business, growth and savings opportunities can pop up at any time and might require additional funds.  For example, you might have the chance to save considerably by buying additional inventory or you might need an important piece of equipment to keep your business moving along. Additional funds can also help make payroll or beef up cash flow to get through a seasonal slump.

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If you don’t quite qualify for a low-cost loan, like an SBA loan or some traditional bank loans, there are other ways to access funds. A small business line of credit is one option. Here’s what you need to know about this funding option.

What is a business line of credit?

A business line of credit is a financing option that falls somewhere between a business credit card and a term loan. An outright loan is a lump sum of borrowed money, but a business line of credit is a revolving line you can draw against as you need it. Virtually the only similarity a line of credit has to a small business loan is that it gives access to funds that can be used for day-to-day expenses. Otherwise, a business line of credit is more like a credit card. You don’t have a sum deposited into your account which you then repay with interest on a regular basis. Instead, you draw funds as you need them and accrue interest each time. Lines of credit are also revolving, like credit cards, which means that the amount you repay becomes available again. As with credit cards, your lender will determine a maximum up to which you can withdraw funds at any given time.

Some lines of credit have a draw period. This is an amount of time you can withdraw funds. For instance, a 2-year draw period allows you to withdraw money for a period of 2 years.

Lines of credit can be extended by a large bank, a small local bank or an alternative online lender.

Pro Tip: Determine if you qualify for a low-cost SBA loan before you apply for a line of credit. Check out SmartBiz Advisor, a free educational tool that generates the unique loan ready score for your business and offers advice to improve your financial profile before you start an SBA loan application. Learn more here.

How does a business line of credit work?

Here’s a simple example:

If you receive a $10,000 line of credit and use $5,000 for inventory, you only pay the $5,000 plus interest back. In the future, you can withdraw more, but only up to the $10,000 limit.

Different types of lines of credit

Traditional Secured Business Lines of Credit You’ll need to put up collateral, something of value like real estate or equipment, for this type of credit line. The lender can claim your collateral if you default, lowering their risk and resulting in lower interest rates or more flexible payment terms than an unsecured line. You might also qualify for more money than you would with an unsecured line.

Unsecured Business Line of Credit

Collateral is not required for this type of credit line. There’s nothing to seize if you default so the lender is assuming a larger risk than with a secured line. The additional risk can make an unsecured line of credit more difficult to acquire and more expensive.

Short-Term Lines of Credit

A business line of credit isn't like a term loan, but lenders consider similar information to qualify like your credit score, time in business and revenue. Short term lines of credit can be accessed quickly and are easier to qualify for than a longer term credit line.  However, you pay for the speed and convenience with higher APRs. Be sure to read the fine print.

Longer-Term Lines of Credit

This type may be less expensive but harder to qualify for than those with shorter terms. Longer term lines of credit have higher amounts giving you access to more cash. The biggest benefit is a lower APR.

Pro Tip: Look at your cash flow and income statement to determine the best fit for your immediate needs. If you can wait, try to improve the financial health of your business so you qualify for low-cost funds. It’s a good idea to check with your accountant, bookkeeper, or another financial professional to make sure you’re not getting too much that will crunch your cash flow. On the other hand, you want to access enough so you can meet your goals.

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When it is useful to open a line of credit?

The number one reason to use a business line of credit is for short term funding needs.  A line of credit can be used in a variety of ways:

  • Purchasing inventory: If a particularly busy season is coming, running out of funds could be a disaster. Look at past years and adjust for your expectations based on that data.
  • Purchasing or repairing equipment: Most small business use computers, printers, scanners, and copy machines. With technology rapidly expanding, funds can be used to upgrade equipment and software. If you have a break-down of any equipment used for your business, repairs can be covered by a line of credit.
  • Financing marketing campaigns: You can’t sell your products and services until you’ve found your consumer audience. Marketing is key and a line of credit can cover costs related to website upgrades, social media campaigns, advertising, and more.
  • Making payroll: Your team is vital for the success of your operations and ultimately the bottom line. Use funds to make sure you’re paying your workers on-time and in full. You can face legal issues if you’re not handling payroll correctly.
  • Building credit: Another important benefit of a line of credit? It’s a helpful tool to consider before applying for lower cost funding as it can help you build solid credit making you more attractive to lenders. Your credit report is usually the first thing considered by lenders.

Pro Tip: If you don’t need immediate funds, skip a line of credit and look for a small business loan with low rates and long terms like an SBA loan.

What you should consider when opening a line of credit?

Unlike a loan, which generally is for a fixed amount for a fixed time with a prearranged repayment schedule, there is much greater flexibility with a line of credit. There are also typically fewer restrictions on the use of funds.

Pro Tip: Consider a line of credit if you need cash fast or want to strengthen your credit profile.

Tips for using a line of credit

Before you take out a line of credit — secured or unsecured — check your credit scores and take steps to boost your scores to improve your chances at qualifying for a lower interest rate. If you’re borrowing because you’re trying to avoid getting into financial trouble with another loan, you run the risk of getting caught in a borrowing cycle – never a good idea.

Another important thing to keep in mind is when not to use a line of credit. Reasons to avoid this type of funding include:

  • If you know you can’t afford payments or you have unstable cash flow, a line of credit might not be a good choice. If you default, your credit scores will suffer and you might lose collateral if you have a secured line of credit.
  • If you know exactly how much you need and you don’t want to use collateral, you may be able to find a business with better rates than an unsecured line of credit, depending on your creditworthiness.
  • If you’re using the line of credit for basic needs instead of funding that with income, it could be a red flag that you’re struggling financially and shouldn’t take out new debt.

The bottom line

A line of credit can be an excellent way to access fast cash and build your credit. However, you shouldn’t rely on a line of credit for long term funding. Explore a low-cost SBA loan with long terms for working capital, high interest debt refinance, or real estate purchases.

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