How Does A Business Line of Credit Work?
A one-time lump sum business term loan isn’t always the right financing fit for your small business. Sometimes, you need flexible access to funds you can tap on your own schedule to cover payroll, take on a new project or restock inventory ahead of a busy season.
That’s where a business line of credit comes in.
It gives you access to working capital when you need it — a great fit for businesses looking to take care of ongoing expenses. Understanding how a business line of credit works can help you decide if it’s the right fit for your business.
What is a business line of credit, and how does it work?
A business line of credit is a type of small business loan that gives you access to a set amount of funds. This is referred to as your credit limit, and you can draw from it as needed. You’ll typically only pay interest on the amount you borrow, and you can reuse the funds as you repay them.
Many small business owners use lines of credit to help manage cash flow, cover operating expenses or bridge seasonal slowdowns. They can also be used to keep things running smoothly while you’re investing in growth, even if you face some unexpected expenses.
Finding the right option
Not all lines of credit are the same, and it’s worth doing some research to find the right lender before applying. Here are some things to consider when looking for the right option:
Secured vs. unsecured. Secured lines of credit require you to back the funds with valuable business assets like real estate or equipment, but typically come with a lower cost of borrowing.
Eligibility requirements. Traditional financial institutions like banks and credit unions often have strict requirements around things like credit score, annual revenue and time in business. Alternative lenders, like online lenders, may be less strict.
Speed and simplicity. Online business lenders often offer a simple application and quick approval decision, while traditional lenders may have a longer application process and require years of financial statements, tax returns and other documentation.
Finding the right line of credit for your business can take some work. Before you start an application, make sure you meet the eligibility requirements and that what the lender is offering fits your business needs. You should also consider reading online reviews to ensure they offer good customer service and transparency around borrowing and costs.
Applying for a business line of credit
The process for applying for a line of credit will vary by lender, but in general they’ll want to know how your business is performing and how likely you are to repay what you borrow. Here are a few things they may ask you to provide:
Business details. This includes things such as your business’s legal name and address, your business structure and your tax ID or EIN.
Time in business. They may ask how long your business has been operating.
Annual revenue. Most lenders will have a minimum annual revenue you need to meet to be eligible.
Financial documents. You’ll likely need to submit some documents such as bank statements.
Credit history. Many lenders will check your personal credit score to evaluate your creditworthiness, but a strong business credit profile can be beneficial as well.
Some lenders can approve applications quickly, within a day or so. For others, credit approval may take up to a week or more, especially if they require additional documentation.
Drawing funds from a line of credit
If you’re approved, you’ll be given a credit limit, which is the maximum amount you can draw from your line of credit. You typically don’t have to use it all at once — most lenders let you draw funds as you need them.
For example, you might need $5,000 to help with purchasing inventory in bulk. As long as you haven’t reached your credit limit, you can draw what you need — and if something else comes up, you can draw again.
How interest and repayment work with a line of credit
With most business lines of credit, you’ll only pay interest on the amount you borrow. For example, if you have a credit limit of $50,000 and draw $10,000 — you’ll only be paying interest on the $10,000 that you borrowed. This makes lines of credit a flexible financing option that helps put you more in control of your borrowing costs.
Repayment terms can be different depending on your lender. Some lenders may require a weekly or monthly payment that includes both principal and interest. Others may offer an interest-only draw period, where you only have to pay the interest on what you’ve borrowed.
Some lenders may also charge fees such as an annual fee, a draw fee or a monthly maintenance fee. Be sure to read your loan agreement carefully to be sure you know what you’re paying.
What are some alternatives to a business line of credit?
Business credit card. A business credit card is a type of revolving credit. It can be useful for smaller business expenses like travel or office supplies. Some may offer perks like cash back or rewards. However, lines of credit typically come with a higher credit limit.
Business term loan. Business term loans offer you an upfront lump sum of cash to use for your business. They’re then repaid in fixed installments over time. They can be a good option if you have a large one-time expense, but if you need more funds you’ll have to refinance or reapply.
What’s the difference between a line of credit and a business credit card?
The difference between a line of credit and a credit card is how the funds are accessed and used.
Access. Funds from a line of credit are typically drawn and deposited into your business checking account. With a credit card, you typically just swipe and charge the account.
Usages. There are certain things a business credit card can’t be used for, like covering payroll, paying rent and certain utilities or taxes. However, because a line of credit puts cash into your account, it can be used as cash to cover these expenses.
What’s the difference between a secured line of credit and an unsecured line of credit?
The difference between a secured line of credit and an unsecured line of credit comes down to whether or not you need collateral to secure the credit line.
With a secured line of credit, you’ll need to offer business assets such as equipment, inventory or real estate. While secured lines can have lower interest rates, you also risk losing your collateral if you fail to repay. Additionally, if you’re operating a business that doesn’t need a lot of physical assets, such as a digital or service-based industry, you may find it hard to qualify.
Unsecured lines of credit — like other unsecured business loans — don’t require collateral for you to qualify. The lender will still look at your business’s cash flow and may request a personal guarantee. However, an unsecured line of credit may have a higher interest rate.
What is a draw period?
A draw period is the time frame during which you’re allowed to access funds from your business line of credit. This can be anywhere from a few months to a few years. Repayment during this period may be interest-only. After it ends, you’ll start to pay down the principal.
Not all lines of credit have a draw period. Some can stay open indefinitely as long as the account is in good standing. If you’re considering a line of credit, knowing the difference can help you make the right choice for your business.
When is a business line of credit a good option?
A business line of credit can be a good option when you need flexible, ongoing access to funds. If you need a financing option that can help you manage cash flow gaps or fund a long-term project, a line of credit may be a good fit. It can also act as a safety net when unexpected expenses pop up.
The Bottom Line
A business line of credit can give you the flexibility to manage short-term expenses and keep operations running smoothly while you take on new opportunities. But like any financing option, it’s important to understand how it works, and that it will fit your business and financial needs.
