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?

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. You only pay for the money that you use. Lines of credit can be extended by a large bank, a small local bank or an alternative online lender.

Lines of credit have advantages over regular business loans. The use of funds is flexible, there are no set monthly payments and no interest is charged on the unused money in the account. When you repay a borrowed amount, those funds are immediately available again.

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.

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.

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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
  • Purchasing or repairing equipment
  • Financing marketing campaigns
  • Making payroll

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 Should You 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.

Pros and Cons of using a line of credit

Make sure you’ve explored all of your funding options and looked at the good and bad of a credit line when researching.

Pros

Some of the biggest advantages of a business line of credit are that you only pay interest on the funds you use and that the capital is available whenever you need it. You can use the proceeds for a wide variety of business purposes to help maintain your cash flow, from operating expenses to purchases to emergency funds. Another benefit is that most businesses are eligible, even if they’re young or don’t have the highest credit scores. Being consistent and timely with your interest payments can also help you build your business credit so you can work towards obtaining the lowest cost funding options in the future.

Cons

The most glaring drawback of business lines of credit is that they can have high interest rates, especially for borrowers with lower credit scores. While they can come in handy for immediate, short-term business needs, they can become costly over time as you withdraw more capital.

In Conclusion

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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