line of credit is a perfect example of what’s called a revolving account. Basically, the money can be spent and repaid on an almost endless cycle. This differs from traditional loans which are repaid in equal monthly instalments vs. simply repaying whatever you use.
What is a Line of Credit?
While a line of credit is a form of a loan, it is different from the idea of a traditional loan where the entire amount is given to you at once and then you must pay it back in. A line of credit is essentially an agreement between you and a lender. This agreement will establish a specific balance that you, the customer, will be able to pull from and use as needed. You can use the money at any time and for any reason, so long as you do not go over the limit.
A business line of credit can be a valuable tool for small businesses that take a strategic approach to making sure they have access to the resources they require to meet day-to-day working capital needs and fill other short-term financial necessities. It allows them to apply and qualify today for borrowed capital they may need down the road. Many businesses use a line of credit as part of a larger capital access approach including short-term and longer-term financing to fuel growth and fund other revenue-generating projects.
What Is a Business Line of Credit?
A business line of credit (LOC) is a revolving loan that allows access to a fixed amount of capital, which can be used when needed to meet short-term business, needs. A LOC is one of the tools a business can use to finance short-term working capital requirements, such as:
- Purchasing inventory
- Repairing business-critical equipment
- Financing a marketing campaign
- Bridging a seasonal cash flow gap
There are two types of business LOCs:
- Secured Business Line of Credit—This type of LOC requires the business to pledge specific assets as collateral to secure the line. Since a line of credit is a short-term liability, lenders typically ask for short-term assets, such as accounts receivable and inventory. Lenders don’t often require capital assets, such as real property or equipment, to secure a LOC. If the borrower is unable to repay the line, the lender will assume the ownership of any collateral and liquidate it to pay off the balance.
- Unsecured Business Line of Credit—This type of LOC does not require specified assets as collateral—however a general lien and personal guarantee will likely be required. Because there is no specified collateral associated with this type of credit line, the business will likely need a stronger credit profile along with a positive business track record to qualify. Additionally, interest rates may be slightly higher; and unsecured credit lines are often smaller.
A Business Term Loan vs. a Business Line of Credit
From a lender’s perspective (both traditional lenders like banks and online lenders offer business credit lines) a line of credit and a term loan are very different. For example, when a lender evaluates your creditworthiness for a term loan, they are looking at a business’ credit profile to make a decision about a loan today. For a line of credit, they are looking at a business’ credit performance today, to make decisions about the creditworthiness of the business at some time in the future when it accesses the credit line. To a lender, these are two very different situations and could explain why the qualification process for a line of credit might be a bit more thorough.
That’s not the only difference between a term loan and a line of credit. A term loan involves a fixed amount of funds, which the business receives in a lump sum once the loan is approved. Periodic payments are typically repaid over a defined period of time, or term, in a prearranged schedule of payments until the balance is paid in full.
A business line of credit also includes some additional flexibility that is not part of a small business loan. A LOC is fundamentally a credit limit a business can borrow against whenever they need it, repay, and use again—often for a specified term. Most lenders require the LOC balance be brought to zero at some time during the term of the credit line.
LOCs are often used for short-term operating purposes and for more immediate revenue-generating activities because the business can access the funds as needed.
How Does a LOC Work?
When you open a business line of credit, the business receives access to a stated amount of funds to use as needed. A monthly statement reflecting the amount of credit used will also include any interest charges (unlike a term loan, you only pay interest for the funds you use as you use them).
As mentioned above, your payment, and the interest is based upon the funds you use. Once repaid, the credit limit is available to be accessed again as needed. The periodic payment schedule to repay a line of credit will vary depending upon the lender. Either a weekly, or monthly, periodic payment schedule is common.
In addition to the interest charges, an annual fee for a LOC is not uncommon. If your business frequently accesses the LOC, transaction fees may also apply.
Small LOCs (under $100,000) can operate like a credit card account, with advances made by using a credit card tied to the line of credit or by writing checks issued for the account. Some lenders also offer the option of depositing funds directly into the business bank account via an ACH deposit.
When Should a Business Consider a LOC?
If your business regularly requires access to funds to meet short-term capital needs to manage the business’ day-to-day capital requirements, then applying for a LOC might make sense. Here are a few examples of situations where a LOC could be a good idea:
Example #1: A seasonal business that generates most of its sales in the summer could use a LOC in the offseason (provided they had the cash flow to make the periodic payments) to help cover overhead as they bridged from one season to the next. The LOC could allow them to maintain normal business operations even though their income fluctuates.
Example #2: A small business could use a LOC to finance a marketing campaign, which would attract new customers and expand sales. The borrowed funds could be paid off quickly because the campaign would potentially generate additional revenue.
Example #3: If a business needed to cover expenses while waiting for a client to make payments on an invoice, a LOC could be useful for cash management.
A new business without an established business credit profile or a business owner with a low personal credit score will likely have a difficult time qualifying for a LOC. Most lenders prefer to offer a LOC to more established businesses with a track record and revenues to support the more flexible financing provided by a line of credit.
Who Offers Business Lines of Credit?
Most major banks that serve small businesses—including commercial banks, community banks, in addition to credit unions—offer business lines of credit. Many online lenders, like OnDeck, also offer business lines of credit.
Lenders will usually only consider more established businesses with a positive credit history for a line of credit. For new businesses (under 2 years old), some banks offer LOCs to help finance their short-term capital needs.
Applying for a Line of Credit
Like a term loan, most lenders will want to see financial records and documents that demonstrate a track record and demonstrate creditworthiness. Traditional lenders like banks and credit unions will require some additional documentation online lenders might not require, so it’s a good idea to find out before your first meeting with the lender what will be required. Some of the basic information you’ll need to apply could include:
- Business License
- Tax Returns
- 2-3 months of bank statements
- A business bank account
- Standard financial documents like P&L, AR, AP, Cash Flow, etc.
You should be prepared to discuss the specifics of the business’ financial position with the lender, so any documents you may be unfamiliar with you should consult with a trusted advisor like your accountant or CPA to make sure you understand exactly what the documents suggest about the financial health of your business.
As a general rule, lenders will rarely offer a LOC to:
- Idea stage companies or startups
- Cover losses on past operations
- Meet immediate expenses that won’t necessarily lead to profits
To demonstrate the business is qualified for a LOC, be prepared to show:
- The business is profitable of generating additional revenues
- Management understands the financial aspects of running a business
- The business has a plan for the LOC to cover specific expenses at specific times and can demonstrate its ability to make the periodic payments
What You Need to Know Before Opening a Line of Credit
Before opening a LOC, make sure you understand your chosen lender’s qualification criteria, loan conditions, interest rates, and fees.
- There may be charges for account set-up, transactions, and annual fees. For example, a bank may charge an opening fee of $150 (or more depending upon the credit account) with no annual fee for the first 12 months, but an annual fee at the beginning of the second year.
- In order to reduce risk, it’s not uncommon for the lender to require the business pay down their outstanding LOC balance to $0 at some point during the year, often for at least 30 days. This assures a lender that the borrower is generating sufficient cash flow to operate independent of the LOC, and not relying on the financing as a substitute for cash flow or owner’s capital.
- Due to the unpredictable nature of the market, a lender might reserve the right to call any LOC payable immediately. This means the full balance would have to be paid and the LOC reduced to zero without warning. If your business depends on the line of credit, this can be a critical impediment, so the business should always be prepared to either replace the LOC or scale back in order to weather the loss of credit.
3 Tips on Keeping a LOC
- Periodically pay down your balance and avoid keeping your average running balance near your credit limit. This will show your lender you know how to leverage the value and flexibility of the LOC.
- Using a LOC to cover operating losses is not the best option—it will make repayment difficult.
- Think strategically about your capital needs for the year to determine the best time to apply for a LOC. Lenders are more inclined to grant a credit line when the business cash flow is strong.