Running a business certainly has its ups and downs—especially when it comes to finances. Whether you’re just starting out, sustaining or growing an established business, you might experience a surplus one month and then dip into the red the next. So, how do you manage that risk and ensure you have some financial stability to run your business effectively?
Along with a business credit card and term loans, a line of credit is definitely another option to consider. And maybe you already have—FitSmallBusiness claims that 47% of small businesses have opened a line of credit.
However, there are many misconceptions around what this product actually is. What exactly does it mean to have a business line of credit, and what are the pros and cons?
We made this comprehensive guide to help you navigate the decision of whether or not to open a business line of credit.
What Is a Line of Credit and How Does It Work?
What it is: A business line of credit is flexible “revolving” capital that works almost like a credit card, except you get access to cash and, in some cases, lower APRs.
It’s a flexible financing product that lets you withdraw funds up to a predetermined amount—this means you can withdraw funds as you need it, as opposed to receiving the full sum of the loan all at once. A business line of credit is typically used for short-term working capital needs, such as inventory purchases, future project costs, or company payroll.
Where you find it: Banks can be a good place to look for credit lines, but a number of alternative online lenders might have quicker, easier application processes or requirements. Banks have high minimum qualifications and often require specific collateral, while online providers can be far more flexible.
To find the perfect fit and absolute best terms, you should plan to compare options between several lenders—so don’t wait until you’re desperate for capital.
What you need to provide: To obtain a business line of credit, you probably need to supply some personal and business financial information, so be prepared with income and other statements or tax returns. The maximum amount of funding available, introductory duration of the credit line, and repayment terms depend on your business’s annual revenue, credit rating, history, and other factors.
What credit lines offer: Credit lines can range from $10,000 to as high as $1,000,000, depending on your business needs and qualifications. Terms are usually annual with an interest rate based on the prime rate, plus 1% to 3%.
Interest rates vary as the market changes, of course, but many lenders let you withdraw funds—via paper check, online, check card, or other methods—for no fee or very small fees. However, you can expect to pay a modest fee to open the account once you’ve been approved. For example, you might be charged $150 for credit lines under $25,000 and $250 for larger credit lines. An annual fee is often waived for the first year, and may run $100-$150 annually thereafter. Payments are interest-only on the amount you borrow.
Now that you have an idea of how this works, how do you decide?
- Fast cash when you need it. A small business credit line lets you draw funds when you actually need them. This means you’re not stuck paying interest on borrowed money if you don’t have an immediate need for it. Once a credit line is established, drawing funds is usually the fastest way to access capital (aside from accessing your own cash).
- Even out your cash flow. While every business should have a cash cushion available for times when the market is rougher, sometimes a crisis lasts longer than the money does. You can’t always predict needing an additional employee for a sales spike or being unable to pay the ones you have because a client has yet to pay you. A business line of credit helps you manage that risk.
- Build good credit. Small businesses need to build credit history to obtain future credit accounts and loans. Using a line of credit lets you build a positive business credit history as you use the line and make the payments on time. Businesses that use their lines of credit in a careful and deliberate manner may see their business credit rating increase, which can be helpful when seeking other loans and credit lines.
- Build relationships with lenders. One of the best aspects of negotiating a line of credit is the relationship you build with the lender. Over time, this might help you when you need additional financing for other projects.
- Flexibility. Lines of credit don’t always require you to provide a reason for the loan, which lets you use your credit on what your business needs on a moment-to-moment basis.
- Smaller borrowing limits. Credit lines typically have smaller borrowing limits than term loans, which make them ideal for unexpected charges but not for large capital investments.
- Very new or very small businesses may have trouble qualifying. Even those small businesses that meet high qualifications for a top-tier business line of credit at a bank might find it difficult to obtain one unless they bring other business or accounts with them. This is because credit lines are less predictably profitable for lenders (compared to a term loan, for example). As such, banks can be reluctant to offer them as a stand-alone product. When you apply for a line of credit, your bank may require that your business be at least 2 years old. Unlike with, say, a business credit card, you might be asked to provide extensive financial reports including tax returns, cash flow statements, and more.
- There are costs. The costs involved in establishing and maintaining a line of credit can be a drawback. Establishing a line of credit requires up-front fees to obtain the line. In addition, the business must pay interest on the money it uses from the line of credit. While you may have to pay higher interest rates on business credit cards, lines of credit can result in more fees for maintenance and withdrawals. Make sure your interest rate is low enough to justify any added fees.
- It is, after all, more debt. This may seem obvious, but it should definitely be a consideration. When money is tight, a line of credit can create a cash infusion to a small business, but of course, a line of credit is debt that has to be repaid, which can be problematic when finances are tight. “While a line of credit is nice to have on hand for an emergency,” says TheSelfEmployed.com, “you could ultimately find that you have spent the entire amount you have access to, and are unable to repay it because of a business slowdown. In some cases, businesses may be better off with a standard loan to avoid the temptation of access to immediate cash.”
- Higher credit risk. “A business line of credit can also put your small business at risk,” according to The Small Business Chronicle, “even if your business fails, a line of credit is a business obligation that has to be repaid.” Personal liability to repay the debt depends on the structure of your business. For example, a sole proprietor may be liable while a corporation may relieve you from any personal obligation.
There you have it! Regardless of your business size or type, a credit line can be very helpful, but before you apply, make sure you understand the potential risks and downsides. But if your business is equipped to handle them, the benefits could far outweigh the risks and downsides. Of course, as the old adage goes, it takes money to make money!
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