A business line of credit is a financing tool that provides firms with advantages not available from business credit cards or term loans. Unlike loans, business lines of credit let companies borrow only what they need and only get monthly bills if they draw on the credit line. Unlike credit cards, business lines of credit offer easier access to cash and lower interest rates. These lines of credit can be part of an overall approach to capital access and cash flow management that includes terms loans and business credit cards.
How Business Lines of Credit Work
Business lines of credit are revolving credit arrangements and, thus, bear similarities to credit cards. These lines of credit are subject to a credit review and typically are renewed annually. A business line of credit has a cap on the amount that can be borrowed. But, until cash has been withdrawn for a business use, no payments of principal and interest are required.
The cap on a business line of credit is usually lower than the amount it could borrow with a term loan. Interest rates are also usually higher than term loans. These differences are to reflect the different risk taken on when a lender extends a business line of credit.
The two major types of lines of credit are secured and unsecured. Secured lines of credit require the borrower to pledge assets as collateral. The pledged assets often consist of inventory or accounts receivable. If the business defaults, its lender can take the collateral. Unsecured lines of credit don’t include a pledge of any specific assets as collateral. Instead, the lender often will take a lien against the business and require a personal guarantee from the owner. Unsecured lines of credit tend to be harder to get and have higher interest rates.
Lenders also often charge origination fees and annual fees from $100 to $500. These fees are generally tied to the size of the line of credit. Lines of credit may be available for amounts from $1,000 to $500,000.
Once the line of credit is approved and set up, the business has access to an amount of funds up to the limit. Borrowers can tap the cash by writing a check to a supplier, using a business credit card or transferring funds online, perhaps with a mobile banking app.
Each month the borrower will get a statement showing how much of the available credit has been used and interest charges for that month. If no funds have been borrowed yet, there won’t be any interest charges. Lines of credit typically carry interest rates ranging from 8% to 24%. Rates may be pegged to the prime rate and can change over time.
Uses of Business Lines of Credit
A business line of credit is usually not designated to fund a specific transaction, other than to help the business generate profits. A loan, on the other hand, typically is tied to a particular purchase such as property or equipment.
In practice, business lines of credit provide working capital to smooth monthly cash flow. They are often used to purchase inventory and pay suppliers and vendors. They may also be used to cover cash flow gaps and working capital needs for seasonal businesses as well as funding advertising and marketing programs.
New firms sometimes take out a business line of credit, withdraw a small amount and then quickly pay it off to establish a favorable credit profile.
Applying for a Business Line of Credit
Most banks, credit unions and online lenders offer business lines of credit. The Small Business Administration backs lines of credit through its network of affiliated lenders.
Lenders consider lines of credit riskier than term loans. So, in addition to charging more interest, they have higher standards for approval. Typically, they’ll look for established businesses that are generating profits now and will earn more with the help of the line of credit.
To prepare for an application, borrowers should assemble these documents:
- A description, including business name, tax number, type of business structure, owners, industry and number of years in business
- Licenses required for the business to operate
- Signatures from owners
- Tax returns for the last year or two
- Bank statements for the most recent two or three months
- Financial statements, including profit and loss, cash flow and accounts payable and receivable
- Relevant contracts such as customer orders
- Any other loans the business has outstanding
Generally, a successful borrower will demonstrate that its managers are financially savvy enough to use the money wisely. The borrower will have a plan for how it will use borrowed funds to cover expenses needed to produce profits. Finally, the business will need to show it can produce enough cash flow to make the payments.
The Bottom Line
A business line of credit can be an important part of the way a business funds its operations, and it can be used with business credit cards and term loans as part of an overall capital access strategy. With more flexibility than a term loan and lower costs than credit cards, this form of revolving business credit can help fill in future cash flow gaps, get through seasonal fluctuations and allow a business to achieve higher sales and profits.
Tips for Small Business Owners
- Consider working with an experienced financial advisor if you are thinking of applying for a business line of credit. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Tax season can put a temporary strain on a small company’s finances. Understanding and making wise use of all available small business deductions and credits could spare a firm from having to pay taxes with borrowed money.
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