Every business passes through sweet (non-challenging) and bitter (challenging) moments. Some of the sweet moments may include an influx of cash from high seasonal sales or new clients. The bitter moments can include financial constraints due to losing a major client, unexpected disasters, or an economic downturn.
But regardless of which moment you are going through, every business needs a line of credit to push its growth and expansion, help cover unexpected hurdles and manage growing financial needs.
However, a business line of credit only covers short-term financial needs like urgent unplanned expenses, late invoice payments, supplier payments, payroll, and other cases where cash flow is uncertain. In these instances, access to a line of credit can mean the difference between surviving and closing your business.
Let’s explore more on how business lines of credit work
Understanding a business line of credit
A business line of credit is a revolving loan that allows businesses to access a fixed amount of funds they pay later. It enables business owners to draw funds against their established credit limit, which they can borrow, repay and borrow again.
Unlike a traditional loan, a line of credit is revolving and not fixed, which means you can borrow and repay anytime without any additional repayment fees.
How a line of credit works
When you have a business line of credit, you receive a specified amount of funds to use as needed.
You will receive a monthly statement that reflects the utilized credit amount and any applicable charges. Unlike term loans, a business line of credit interest is only applicable to the used funds.
Once repaid, your credit limit becomes available for immediate use.
Repayment
The typical repayment period includes weekly, monthly, or quarterly. Interest charges, an annual fee, and transaction access fee, are applicable.
The interest fee typically applies to the amount accessed, and it may be variable or fixed. Variable interest rates change as the economy changes while the fixed one remains constant. Interest rates can range from 5 to 20 percent.
Traditional banks offer a more relaxed repayment period, with some offering a draw period in which a borrower can make interest payments and still access the funds.
After that, the borrowers enter a repayment period and clear the outstanding balance within a specified time. On the other hand, online lenders offer a short-term repayment period that’s fully amortized over 6-24 months.
Requirements for getting a business line of credit
Most lenders require you to have operated for six months with a minimum revenue of $25,000. This enables them to determine your ability to repay the loan.
Your credit score requirements vary from one lender to another, but generally, it’s advisable to have a good credit score.
When does a business need a line of credit?
If your business frequently requires short-term capital to manage its daily operation, it makes sense to apply for a line of credit. Examples include;
Example 1: A seasonal business generating most sales during the summer could require cash flow assistance during the off-season period to cover overheads as they wait to bridge to their high season. A business line of credit allows the business to maintain everyday business operations even with fluctuating income.
Example 2: A small business starting a marketing campaign may need a line of credit to help expand its sales and attract new customers. The company may repay the funds quickly as the campaign generates more income.
Example 3: When a business needs to cover unexpected expenses as they wait for a major client to make payment, a line of credit may become an important cash management option.
Keep in mind that lines of credit have fewer requirements and offer flexibility, but those with variable interest rates may incur higher charges in the course of their repayment.
Where to apply for a line of credit
Business owners can apply for a line of credit from:
- Online lenders
- Credit unions
- Banks
When choosing your ideal lender, compare interest rates, minimum amount, funding speed, personal credit score, lending fees, and loan borrowing cost. Online lenders easily forgive those with low credit scores, but many offer lower loan limits.
Documents needed to apply for a line of credit
Any of the above lenders may ask for documents like;
- Personal tax returns
- Business tax returns
- Bank account information
- Your business registration and financial documents like AP, AR, P&L, and cash flow.
When to apply for a line of credit?
Here are some factors to consider when finding the right opportunity to apply for a business line of credit.
- When you have a strong credit score: A strong credit score enables the business to enjoy lower interest rates and a high loan limit.
- Revenue is trending up: Regardless of your preferred lender, they require a business owner to have a certain annual income. The lender may calculate your loan on a higher average when your income is higher. The higher your business revenue income, the higher your loan limit.
- Your business hits a significant milestone: Lenders look more favorably on companies that continue to grow and hit a milestone in credit score and revenue. As business milestones increase, lenders often offer better interest rates and repayment periods.
Types of business lines of credit
A business line of credit can either be unsecured or secured.
- A secured line of credit: The lender usually asks the borrower for collateral, and since it’s temporary funding, they may accept accounts receivable or inventory.
- An unsecured line of credit: Business owners prefer an unsecured line of credit since it doesn’t require any collateral. However, since it’s a risky business for the lender, the vetting bar for the companies is relatively high. You need good business credit, personal credit, and an excellent revenue record. Additionally, an unsecured business line of credit comes with higher interest rates and lower limits.
Is it advisable to get a business line of credit?
Lines of credit have both cons and pros and they include:
Pros
Flexibility: Once the line of credit is approved, your business can quickly access it and draw the funds whenever needed. Furthermore, lines of credit work in a revolving manner, meaning as soon as repayment is done, you can access credit immediately. Additionally, the registration process is only once.
Partial interest repayment: With a line of credit, you only pay interest on used funds. For example, if your limit is $50,000 and you use only $20,000, the claim will apply to the $20,000.
Increased credit rating: When you maintain a sound repayment track with your lender, they give a favorable report to credit bureaus, thus enabling your credit score to build. A rising credit rating means getting better interest rates and traditional loans. Always ask your lender to do a report back to the credit bureaus.
Lower interest and fees: Unlike traditional loans and credit card funding, a line of credit has lower fees and interest charges since it operates more on a revolving balance. This means it doesn’t have a fixed repayment period.
Cons
Complicated application process: Sometimes, applying for a line of credit, especially for an unsecured one, can be challenging, but it depends on where you use it. For example, applying for a business line of credit from major banks is quite tricky.
You will need comprehensive documentation like revenue reports, tax returns, the latest comprehensive financial statements and collateral, and personal/business credit score. On the other hand, other lenders, like online ones, require less paperwork.
Extra fees: Although the interest rates for a line of credit are quite favorable, there might be other additional charges like maintenance and withdrawal fees. These expenses can quickly pile up.
Too much debt: With a line of credit, a borrower creates a slippery slope of always being in debt. In case of default or your revenue declines, you can easily fall into long-term deficits. This means a missed payment can lead to higher costs.
Last word on a business line of credit
Many businesses’ lines of credit provide a leeway to meet short-term needs and expand. More so, its flexibility makes it more favorable.
Take your time, evaluate your business needs and decide if a business line of credit can benefit your business. Before committing yourself, don’t forget to read the fine print and check out for hidden fees. However, don’t allow your business to get stuck while a business line of credit could be beneficial.