What is a Business Line of Credit and How Does It Work?

The ability to adapt to change is crucial to the success of every small business. This is especially true during periods of uneven cash flow or times of growth.

An unsecured line of credit can be ideal when you need ready access to short-term cash and flexible fund repayment terms.

A business line of credit resembles a credit card in that you can borrow and withdraw funds whenever you need them up to your maximum limit. Interest is only charged on the amount you take out, and when you make payments your credit limit is restored.

Lines of credit remain one of the most popular forms of funding for small businesses. According to the Federal Reserves’ 2020 Report on Small Business Credit Survey, nearly 88% of financing applicants were seeking a loan or line of credit, and 40% of company owners sought a business line of credit

Defining a Business Line of Credit

A business line of credit is a lending option, often unsecured, offered to eligible small businesses. It functions closer to a credit card than it does a small business loan.

Like an installment business loan (or lump-sum loan), a line of credit gives businesses access to a set amount of money according to pre-set lending terms. Unlike a loan, the cash is not provided upfront and banks usually don’t include conditions for how the money can be spent. Instead, the company can utilize its funds as needed.

How a Line of Credit Works

Once your company draws any amount of money from its line of credit, your lender starts charging interest. Interest is usually charged monthly.

As mentioned above, a line of credit is a “revolving” debt. This term means that once your company repays a portion of its loan, the money becomes available to borrow again. It can be used over and over as long as it never goes over the total lending cap.

Advantages to a Business Line of Credit

The main advantage to a business line of credit is flexibility. You do not have to take a full amount in a lump sum, and you can tap into the money only when you need it. It is considered a cost-effective form of financing because you pay interest on the funds you draw on, not the full amount.

A business line of credit is a useful way to manage cash flow. For example, if your sales hit a slump and you face an emergency, or if you come up short when it’s time to pay employees, you can draw money from your line of credit. Or maybe you want to benefit from buying inventory in bulk, however, revenue is slow. Your line of credit can ensure your company doesn’t miss out.

Keeping your line of credit in good standing can help boost your business credit rating and align you with more desirable loan terms if more financing is needed down the road. By opening a modest line of credit and paying it off quickly, you can rapidly establish a decent credit profile.

Disadvantages of a Business Line of Credit

As with any funding source, a business line of credit comes with its drawbacks.

Rates and Fees

The lowest advertised rates are usually reserved for borrowers with the healthiest credit and financial numbers. Banks and other lenders will often draw you in with low-interest rates, only to tack on additional fees.

For example, some lenders impose a maintenance fee while others charge for every withdrawal you make. Still, others levy no fees. Companies can pledge collateral to qualify for lower rates, though these offers still only apply to prime borrowers. Subprime company owners will have to look elsewhere.

Easy to Abuse

Over-using or using a business line of credit for anything other than cash flow shortages could cause financial issues down the road. Additionally, if your firm already has significant debt opening, a credit line may not be a good idea.

Lower Borrowing Limits

Compared to other methods of financing, lines of credit often have lower borrowing limits. Therefore, if your company needs money to purchase new equipment, expand, or fund another expensive project, your business may be better suited for a different financing option.

Make sure to conduct research and compare fees, interest rates, and other costs.

Line-of-Credit Rate Determination

Many factors influence the rate you will pay for a business line of credit. However, it essentially comes down to how the lender assesses the risk level associated with your loan.

• Your credit profile—When viewing your report, banks and credit unions want to see a steady record of loan borrowing and repayments. Lenders usually use individual credit scores and personal guarantees for new businesses and most small business owners.
• Operational history—Lenders view newer companies as a risky bet; however, if you have substantial sales figures or have been operating for many years, your risk level drops.
• Business industry—Lenders usually consider a company’s industry high risk if it is liable to fail. For example, an industry like gambling or alcohol could be viewed as risky because they are susceptible to frequently changing regulations. Other industries, including restaurants or retail, could be considered precarious by lenders because their income is not always guaranteed.
• The prime rate—The prime rate functions as the baseline for setting interest rates on financial products, including credit cards, mortgages, and lines of credit. Therefore, if the prime rate goes up, you will likely pay a higher APR when you apply for your business line of credit.