What is Business Line of Credit & How It Works? Simply put, a business line of credit is akin to a credit card for businesses, permitting the enterprise to borrow money up to a pre-approved limit. The borrower only pays interest on the amount used, and can borrow again as needed. Here’s how it all works.
What is a Business Line of Credit?
A business line of credit allows a business to borrow up to a certain amount and will charge interest only on the amount borrowed. This is also how credit cards work. Interest starts to accumulate once funds are drawn, and as you pay down your balance, the amount paid is again available to be borrowed. Funds are usually drawn through a small business credit card, a business checking account, or a mobile banking app.
As with a credit card, the lender establishes the amount you can borrow. A small business line of credit is also subject to annual renewal and credit review. Note that rates for a business credit line are usually lower than those for a business credit card, which can charge upwards of 20% APR for purchases – and more for cash advances.
Contrast a business line of credit with a traditional loan, where the business would get a lump sum that it would repay monthly with interest.
Why Would a Business Need a Line of Credit?
A business line of credit permits fast, easy access to available funds to cover cash-flow needs, sudden expenses, or major purchases.
The primary reason to open a business line of credit is access to short-term funding, typically to support operational expenses such as payroll or supplies, or for bolstering inventory.
Some businesses also use a line of credit for growth initiatives that need additional funding. Seasonal or cyclical businesses frequently rely on a credit line as a source of working capital until business picks back up.
A line of credit is not like many small business loans, in that you don’t have to stick with a specific purchase or purpose. That’s why it can be an excellent option for small businesses seeking ways to better manage cash flow.
Other Benefits of Business Lines of Credit
Properly maintaining a line of credit can help a business build its credit rating and set it up for better loan terms if future financing is sought. It may be a good idea to open a modest line of credit and erase the debt quickly to build a credit profile.
What Credit Line Sums are Available?
Usually, a business line of credit is offered as unsecured debt, meaning no collateral is required. As such, many business lines of credit have a variable interest rate and are available for totals ranging from $10,000 to $250,000.
What About Eligibility?
That will depend on the lender. Many banks, for example, require a business to have been under current ownership for a certain amount of time. Typically, a guarantor at the time of application will have a FICO score of at least 680.
If you go through an alternative lender, it may take just days for an approval decision. While banks and credit unions usually take longer, they are often able to provide more competitive rates.
Before choosing a lender, you should shop around, comparing features such as:
- Maximum credit limits. How much you can borrow will depend primarily on the lender and your credit score.
- Draw periods. Be certain that you understand the terms of your credit line, such as the amount of time the available credit will stay open for you to withdraw funds.
- Repayment terms. Repayment terms are typically between six to 24 months. Note how long you have to repay the loan once funds are withdrawn.
- Requirements. Make sure your business can meet them. Lenders usually want to see sufficient cash flow to cover repayment, as well as good personal credit.
- Interest rates. This will depend on the lender and your credit worthiness. Typically, rates can run between 8 percent and more than 60 percent.
- Fees. Compare each lender’s fees, which can include a draw fee or a monthly service fee for keeping the line open. There may also be an origination fee of between 1 percent and 3 percent of the loan amount.
In Summary
A business line of credit is a powerful tool for managing short-term cash-flow needs, as it allows businesses to revolve their credit by re-borrowing when necessary.
