In the wake of the 2020/2021 COVID-19 pandemic, many small businesses owners are in need of additional funds to rebuild or move their business forward. You’ve likely received ads in the mail, online, or via traditional media about small business funding solutions, and it’s understandably easy to get overwhelmed.
If you’re in need of access to money “on demand”, you may want to consider a business line of credit. Here’s some information to consider regarding this flexible 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, meaning that you only pay for the money that you use. Lines of credit can be extended by a large traditional 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 when 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 how you will use the funds and adjust your budget accordingly.
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: The business owner puts 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.
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
- Buying 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.
Line of credit pros and cons
- 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.
- Most businesses are eligible, even if they’re young or don’t have the highest credit scores.
- Qualifying for this type of funding is faster and easier than getting a small business loan. Typical loan applications are more involved, as banks want to avoid the risk of non-payment.
- You can immediately charge purchases or access cash, and you only pay back what you've borrowed (with interest, if applicable).
- With a business credit card, depending on the issuing bank, you may receive a sign-up bonus or earn airline miles, shopping discounts, dining discounts, or other perks for using your business credit card. You may also earn cash back on purchases. Business loans don't come with these incentives.
- If you don’t have a good debt-to-income ratio and a track record of at least two years in business, you may not qualify.
- The interest rates on business credit cards are usually much higher than the interest rates on small business loans or fixed lines of credit from a bank. These rates can increase over time, and interest adds up very quickly if you don't pay your bill on time, and in full, each month.
- Exceeding your credit limit or paying your bill late can incur fees and penalties.
- While business lines of credit can help fund immediate, short-term needs, they can become costly over time as you withdraw more capital.
How to qualify for a business line of credit
At a minimum, you'll need at least six months in business and $25,000 in annual revenue to qualify. Although some lenders don't set a minimum credit score, borrowers most likely will need a score of 500 or higher to qualify.
There is no universal yes-or-no answer to whether your business will benefit from taking on a business line of credit. Each business is unique, and each situation is different. 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. It’s always a good idea to check with your accountant or another financial professional before you sign on the dotted line.
WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.