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Business Line of Credit
What is A business line of credit?
A Business Line of Credit is a form of business financing that offers great flexibility. It gives you the option to borrow up to a specific sum for business needs but the interest you pay is limited to the funds you withdraw. The concept is similar to your credit card debt albeit with some differences.
With the business line of credit, businesses can manage short term needs for cash, such as payroll or purchasing inventory, with ease. This is a revolving credit with the funds you pay back becoming available to you once again as long as your Line of Credit remains open. The fact that it is easy to get, uncomplicated and flexible makes this a popular financial tool for businesses, especially medium and small sized firms.
How does a Business Line Of Credit work?
To understand how a business line of credit works, all you need to do is think about how your credit card works. A credit card comes with a maximum limit and you can swipe it at retail locations until you reach that limit. At the end of month, you pay interest for the amount swiped, not the maximum credit limit allowed.
A business line of credit works in the same way, but for your business. Here is a step by step guide to how your business line of credit will work :
Step 1: You identify your financial needs, consolidate them all and arrive at the total funds you need to manage the critical expenses. Sometimes, businesses take out Lines of Credit even before the need actually materializes. This helps them keep funds on hand to quickly fulfil their needs as they arise.
Step 2: Assess your credentials that will qualify you for this type of business finance. Some of the aspects to consider are:
- How long you have been in business
- What is your business’ annual turnover
- How good is your credit score
Step 3: Next, comparison shop various lenders to identify the one offering you the most attractive terms as well as the line of credit that suits your business best.
Step 4: Apply to your chosen lender for the Line of Credit. Along with the application, you may be asked to submit documents that the lender will use to verify your credentials. These may include:
- Tax returns for your business as well as your personal returns
- Bank statements
- Financial statements for your business
Step 5: Between you and the lender, you come to an agreement about the maximum borrowing limit that you have access too under this line of credit. Understand the interest rate, the maximum borrowing limit, and other terms thoroughly. These terms vary from lender to lender.
Step 6: Once approved, you now have access to funds up to the credit limit agreed upon. You can draw any amount of funds within this limit and the interest charged will only pertain to the withdrawal sum. The funds can be withdrawn and used in many ways (depending on your lender): via a credit card, by transfer to your business checking account or even through the lender’s app.
Step 7: Your repayment is based on the interest rate agreed upon and the total sum which you have withdrawn until now. The lender may set a minimum repayment per month. But you can choose to pay off your entire balance when you have funds at hand. This ensures that you have the entire Line of Credit available to you once again for future expenses.
Step 8: Annual reviews may be carried out by the lender to evaluate whether the Line of Credit is to be extended or not.
Who qualifies for A Business Line Of Credit?
You qualify for a Business Line of Credit if your business:
- has been in operation for at least two to three years
- can show strong financials and revenues through its financial statements
- has tax records to show from the past two to three years
Also,
- An applicant with a good credit score (higher than 700) has a good chance of getting approval
- If you are looking for secured LoC, then you also need assets that can be placed as collateral
What are the types of A Business Line of Credit?
Business Line of Credit can be a secured financial instrument or an unsecured one.
- Secured Line of Credit: A secured line of credit has a collateral underpinning the loan. If you need substantial funds via your Line of Credit, the lender may reduce his risk by asking for collateral. This can take the form of a lien over your business assets or a certificate of deposit. If your personal credit score is excellent, the lender may agree to a large LoC on basis of your personal guarantee.
- Unsecured Line of Credit: Most LoCs are unsecured Lines of Credit meaning they are not based on any collateral. Since the lender takes on a bigger risk with these, the funds available may be limited and the interest higher as well. Businesses with low credit score find it challenging to get unsecured Lines of Credit.
Business Line of Credit can also be categorized as revolving credit and non- revolving credit:
- Revolving credit: Also called open ended lines of credit, the funds in these are replenished by your repayments and they can be be used over and over again. In effect, you borrow funds from the LoC, repay it to replenish and then borrow the funds again when needed. The LoC keeps revolving in a cycle giving you a continuous source of funds.
- Non-revolving Line of Credit: This works exactly in the same way as the other but for one difference. When you repay the amount as per agreed terms, the account closes. You have to apply for a fresh LoC to get access to funds again.
benefits of a Business Line of Credit
- You can ensure ready access to funds by taking out a LoC even before a need for funds arises
- These are flexible loans that can be used for virtually any business expense, not limited to only specific expenditures
- You pay interest only on funds used not on the entire credit limit allowed and that means substantial savings
- Revolving LoCs ensure you always have access to funds at hand to address emergencies
- These are simple ways to ensure your business does not suffer cash flow constraints
- Regular payments on your LoC help build a good credit history for your business
disadvantages of invoice factoring
- Unsecured LoCs can be expensive options and also come with fund restrictions
- Secured LoCs place a lien on your business assets
- The rates and the additional fees make these a more expensive affair than short term loans
- These are difficult to qualify for especially if you are a new business
- If not managed properly, you could end up in a vicious debt cycle
What is an example of a Business Line of Credit?
Construction firm XYZ has been in business for three years and is looking to expand its operations. The business is doing well for itself and has some big projects going on that have yielded great profits. The owner also has a great credit score. These factors help him get an Secured revolving Line of Credit to the tune of $100,000.
The firm uses $20,000 on the hiring process for new staff, $30,000 on improving their warehouse, $25,000 on moving to a larger office space. The remaining $25,000 is unused at the end of the year. The firm pays interest only on the $75,000 withdrawn from the LoC, repays it all so it begins the new year with the entire $100,000 of credit available for use again.
Key Points
Key Point 01
One time lump sum, paid down over time.
Use for expansion, capital improvements, and large purchases.
Key Point 02
Cash when you need it most
Use for recurring expenses, payroll, inventory replenishment
Key Point 03
One time lump sum, paid down over time.
Use for expansion, capital improvements, and large purchases.
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Frequently Asked Questions
No, you can draw up to the maximum credit allowed via your Line of Credit at any point during the tenure you agreed upon. You can also draw partially and leave the rest unutilized if there is no need for the funds.
No, only the funds you have withdrawn are taken into account for interest calculation at any point of time. The interest is charged only after you begin to use funds and only on the portion of funds you have withdrawn.
Businesses uses LoCs for a number of short term funding needs such as:
- Making tax payments
- Payroll
- Paying off dues that are past date
- Tiding over revenue dips
- Covering operational expenses
- Purchasing inventory
- Hiring or buying equipment etc.
This depends on the lenders as well as your business credentials but typically LoCs are available from $2000 up to the millions of dollars.
This is something you have to discuss with both your lender as well as the buyer of your new business. If the LoC is backed up by your personal guarantee and you will no longer be associated with the business, the lender may want you to repay and close the credit line.
With a short term loan, you have the entire loan amount disbursed to you once the loan is approved. You pay interest on the loan irrespective of how much of the funds you utilize. The loan ends at the end of tenure once the repayment is complete.
An LoC gives you access to funds for an unlimited time (if a revolving LoC). The interest is charged only on funds utilized not on the entire credit limit you can avail of. Only the funds you borrow are taken out by you in one of many ways outlined above.
It is difficult for new entrants to get LoCs, much less unsecured ones, but exceptions are made when the applicant has an excellent credit score and other credentials backing them.
The lender periodically reviews your business and your repayment with the existing LoC before the funds become available to you again. If you have long standing dues or your business financials are no longer stable, the lender may not want to extend the revolving line of credit.