What Is a Business Line of Credit?
Business Line of Credit
A business line of credit supplies a business with cash much the same way as a fixed loan, but borrowing is optional. A business that needs cash can turn to a business line of credit instead of a fixed loan, applying for it the same way as a term loan. The line of credit can be secured or unsecured, and will carry a variable interest rate. The borrower pays interest only on the amount borrowed, and the credit line replenishes as they repay the borrowed funds.
A business line of credit is a loan that provides flexibility like a credit card, but companies apply for it just as they would a traditional term loan. Lenders determine a qualifying credit line that businesses can access as needed, and borrowers only pay interest on the amount they borrow. The credit line replenishes as they repay the borrowed funds.
Nearly half of small-business owners see cash flow as their biggest challenge. Many use their savings to bridge the gap that results from an income shortfall, while others may rely on credit cards or personal loans. The business line of credit is designed to help companies survive cash-flow fluctuations.
How does a business line of credit work?
Companies apply for credit lines at traditional financial institutions and online lenders. Once they qualify, they can access the funds up to their credit limit. For example, if a business needs funds to make payroll or buy equipment, it can borrow against the credit line and pay interest on the borrowed amount.
Businesses can borrow the funds multiple times as long as they do not exceed their available credit limit. Credit lines operate more like revolving credit cards than traditional term loans, where payments are based on the total loan amount, even if the funds are unused.
How to apply for a business line of credit
Applying for a line of credit is no different than applying for a traditional business loan. Financial institutions, credit unions and online lenders forward applications to underwriters to determine the loan’s level of risk. From that information, the lender assesses the loan amounts, interest rates and repayment requirements for a business line of credit.
The loan terms and qualifying documentation vary from lender to lender. However, most lenders evaluate the following information.
Time in business
Lenders vary on the length of time they require a business to operate before issuing a business line of credit. Traditional lenders typically require businesses to be in operation for at least two years. However, some online lenders offer loans to businesses with as little as six months of operation. Due to these variations, business owners should ask what the minimum requirement is before beginning the application process.
According to the Bureau of Labor Statistics, approximately 20% of businesses fail in their first year. By the fifth year in business, the failure rate reaches almost 50%. This is why lenders require financial statements, income or personal tax returns and bank statements. The higher the credit limit, the more data they require.
Lenders use financial information to calculate economic ratios that estimate business performance. These ratios may include the following:
- Debt to equity: Underwriters look at how much debt a company has in relation to owner or shareholder equity. A high ratio indicates excessive debt, which carries a higher level of risk.
- Current liquidity: Lenders look at the liquidity ratio to assess a business's ability to pay short-term obligations. If the business lacks liquidity, repaying its debt could prove difficult.
- Debt service coverage: This calculation indicates problems with cash flow. It estimates a company's ability to meet its current obligations from its revenue stream. It doesn’t assess daily cash flow but rather the long-term ability of a business to meet its financial responsibilities.
- Fixed-charge coverage: This ratio shows a company's ability to pay its fixed expenses from its earnings. If a business can’t pay its fixed expenses, such as rent and utilities, from its earnings, it’s considered a high-risk investment.
Even if business owners are creditworthy, lenders may require a guarantee or collateral to secure the loan.
What are secured and unsecured lines of credit?
When business owners apply for credit lines, they’re typically looking for unsecured loans; however, most lenders prefer a secured loan. Although secured loans may have more favorable terms, they’re not always the right choice for businesses.
Lenders ask businesses to use their assets to secure a line of credit. These assets may be real estate, inventory, equipment or accounts receivable, and they function as collateral for the business loan. A secured line of credit minimizes the lender's risk; if businesses default on their loans, the lender can use the collateral to repay the loan.
In some instances, lenders may require a business owner to provide a personal guarantee to secure the line of credit. The personal guarantee means if the business defaults on the loan, the lender can use a business owner's personal assets to repay the loan.
Business credit lines without collateral or guarantees represent a significant risk to the lender. If the business owner defaults on a loan, the lender has no recourse to collect on the outstanding debt except through legal action. Business owners prefer unsecured lines of credit because the loans are not attached to their assets.
Unsecured business loans often have lower credit limits and higher interest rates. Small-business owners will need to have excellent personal credit and a proven record of revenue generation to receive an unsecured business line of credit.
Business line of credit vs. business credit card
A business credit card operates much like a business line of credit with a few exceptions:
Getting cash from a business credit card is inconvenient and costly. Cash advances have a daily limit, and most are only for a percentage of the total credit limit. Cash advance fees are a percentage of the amount requested, and credit cards have high interest rates.
A business line of credit is a cash loan that can transfer to a bank account without a fee, with access to the entire credit line amount. With a secured loan, business credit lines have a lower interest rate than most credit cards.
Business credit cards offer 0% interest promotions and sometimes offer rewards or cash back on purchases, while business lines of credit do not. Additionally, credit cards may restrict qualifying purchases to business expenses, and the rewards and cash-back options can provide small-business owners with some added cost savings.
Credit lines have higher limits than most business credit cards. They provide a cost-effective way to afford major purchases. Credit cards can work for smaller purchases that maximize the reward and cash-back benefits but are not the best solution to address cash flow issues.
Benefits of a business line of credit
Poor cash flow is the primary obstacle to business growth, and it’s a leading factor in business failures. A business line of credit can provide the funds to address financial shortfalls that could limit success. For example, clients pay late or office equipment needs replacing. The constant stress of trying to meet financial obligations can take a toll on business owners.
With a business line of credit, companies can smooth out their cash flow. Owners can make decisions with confidence because they have access to funds when needed. For example, credit lines can help:
- Cover payroll
- Launch a new product
- Open a new office
- Purchase new equipment
A business line of credit can ensure liquidity and protect against disruptions that affect operations. It can also benefit a business by offering the following:
The funds from a line of credit revolve. Businesses borrow what they need, repay the loaned amount and access the funds again when the need arises. This gives companies the ability to address operational needs quickly with minimal impact on the bottom line.
Better financial relationships
Small businesses that responsibly manage a business line of credit demonstrate to lenders that they are a good credit risk, which can positively affect future financial relationships. For instance, as companies grow, they may require a credit limit increase. Having a strong relationship with a lender makes this financing process go smoothly.
Higher credit rating
Companies that manage their credit lines carefully and repay their credit lines promptly can raise their credit ratings if lenders report to credit bureaus. Be sure to ask lenders whether they report this information. A higher credit rating can help a company negotiate better terms for its next loan.
With a business line of credit, borrowers only pay interest on the portion of the credit line that they use, while term loans require borrowers to pay interest on the entire loan, regardless of the amount used. For example, a business owner takes out a term loan for $50,000 and deposits the money into the company's account, but they only use $10,000. The monthly payments are based on the $50,000 loan amount, even though the business owner only used a portion of it.
Alternatively, with a business line of credit of $50,000, the business's repayment amount is based only on the $10,000. The company pays less interest because it is only paying on the portion of the loan that it uses. Lenders could also allow organizations to pay off the borrowed balance at any time, lowering the interest even more.
Disadvantages to a business line of credit
A business line of credit may not be the solution for every business owner. Depending on the loan amount, companies may find that a business credit card or a traditional loan better suits their needs.
Lenders have different procedures regarding fees. If business owners aren't careful, they can end up paying more fees than those associated with credit cards. Lenders may charge the following fees:
- Withdrawal fees: Lenders may charge a fee for each business credit line withdrawal.
- Maintenance fees: Lenders may charge a fee for managing the credit line and ensuring that it remains active.
- Inactivity fees: Lenders may charge a fee if there is little to no activity on the credit line account.
Most business lines of credit do not have a prepayment penalty, although some do. Look at the terms before signing to know what fees may apply.
The application process
Lenders often charge an origination fee for processing an application, which can take weeks. Financial institutions can require comprehensive financial information, which is then forwarded to an underwriter. The underwriter’s risk determination can also take weeks. If business owners need the funds quickly, this process may be too slow. They may need to research alternative funding sources to address an immediate need.
Evaluating the options
A business line of credit works for companies looking to cover short-term expenses or unexpected costs. A business term loan may be a better solution for large, one-time expenses, such as equipment purchases. In addition, a business credit card could be a good option for companies with poor credit or businesses that lack the documentation needed for a term loan or a line of credit.