Understanding Lines of Credit
What is a Business Line of Credit?
A line of credit is an amount of credit extended to a borrower. Getting a business line of credit is an important way for business owners to get access to an ongoing source of funds to help manage cash flow, pay bills and otherwise maintain the daily operations of their company. Keep in mind that a business line of credit is a business loan that is intended to help small businesses meet their short-term cash needs. Essentially, a business line of credit helps small businesses grow by giving them an ongoing source of funds to tap into when needed.
Different Types of Lines of Credit
There are four types of lines of credit, which can be mixed and matched (i.e. you can have a secured/unsecured revolving/non-revolving line of credit):
A revolving line of credit means you can borrow from the credit account and add to your balance (within a certain limit) as often as you need it. After borrowing from your line, you’re required to make monthly payments to repay your outstanding balance. You can borrow more money as long as you’re within your limit. Each withdrawal has the same loan terms and is considered one loan, rather than multiple independent loans.
A non-revolving line of credit acts similarly to a revolving line of credit in that you must repay what you borrow. With a non-revolving line of credit, your funds may or may not replenish when payments are made. If your funds don’t replenish at all, you have a non-revolving line of credit. However, if each withdrawal comes with its own separate loan terms, you can see your line replenish as you make payments. This is still considered a non-revolving line of credit because although your line replenishes, each withdrawal is independent of one another.
Secured lines are loans that are secured by your assets. What that means is that you put up some kind of collateral to qualify for funding. This is riskier for your business but not as risky for the lender. Secured lines can offer lower interest rates, better terms and even larger lines. However, if you default on the loan, you lose the assets you put up for collateral and can hurt your credit.
Unsecured lines are loans that are riskier for the lender because you don’t put up collateral for the loan. Unsecured loans can offer higher amounts, additional flexibility due to higher funds and can help you build a relationship with lenders. However, they come with additional costs, can come in shorter loan terms and may come with higher interest rates.
Pro-tip: To avoid having to run up a balance on your business line of credit, add to your business savings whenever possible. By building a financial nest egg, you’ll be less vulnerable to cash flow shortfalls and will reduce your need to borrow.
Business lines of credit vs. loans
Many business owners want to know the differences between a business line of credit and a traditional financing. The distinctions are subtle, but each one offers certain advantages, and it’s important to take these into consideration when deciding which financing option is best for your business. Here are two key differences to keep in mind:
- Interest rates: Traditional financing offers generally fixed rates. Lines of credit interest rates are usually tied to the market’s variable rate.
- Payment structure: Traditional financing has set amounts due each month until the loan is paid off entirely. With a line of credit, payment varies from month-to-month depending on how much funding used the previous month.
- Flexible borrowing: Lines of credit allow businesses to borrow as much or as little money as they need at the time (within a certain credit limit). Traditional loans only offer one fixed amount.
How to get a line of credit
There are a few things you need to have in place before applying for a business line of credit. Here are the top six tips to get a line of credit:
1. Build good credit history from the very beginning of your business.
When most small businesses get started, it’s often a challenge to maintain positive cash flow. Even if you are making lots of money with your product or service, most of that money often is going right out the door to pay for operational expenses, inventory, payroll and general business upkeep. This makes it important to build a good credit history for your business.
2. Do your research.
Check out a few different banks or lenders online to find out their loan terms and compare interest rates to find a good deal on a line of credit. If your credit is less than stellar, consider platform lenders who often make it easier for business owners to get approved for financing even if they have less than perfect credit or have not been in business for very long.
3. Demonstrate a positive cash flow.
In order to get an unsecured line of credit, your business must be able to demonstrate positive cash flow. Your entire business performance will be under review. In addition to your credit history, lenders will consider your past, present and projected future earnings to determine if you qualify for a business line of credit and if so, how much you will receive and at what interest rate.
4. Don’t max out your personal or business credit cards.
As tempting as it may be to use your credit cards for business expenses, be careful! For one thing, maxed out credit cards do not look good to potential lenders – they will hurt your credit score, reduce your ability to get approved for loans and raise your cost of borrowing. And second, consider the extraordinarily high rate of interest you’ll be paying on the credit cards.
5. Start small.
If your credit isn’t great, start small and take whatever line of credit the lender is willing to give you, even if it’s smaller than what you actually need. Make your payments on time or better yet – early (some lenders even offer no early payment fees). As you gradually begin to build your credit history in a more positive direction, you can ask for a larger line of credit.
6. Apply when you don’t really need the money.
The best time to get a business line of credit is when you don’t really need one. Sounds silly, right? But it’s true. Lenders (both traditional and online) are generally more than willing to loan you money when your cash flow is strong, your numbers are great, and you’re not in desperate need of a loan. You might not think you need a business line of credit, but it’s actually great because you’re in a strong position to pay it back immediately. With lines of credit, you don’t have to pay until you take funds. Getting a line of credit when your cash flow is strong can help you with any unexpected funds in the future.
Why a line of credit can work for your small business
Lines of credit are good solutions for businesses with a variety of ongoing business needs and cash flow fluctuations. Most online lenders offer:
- Quicker turnaround times
- Flexibility of funds
- Online applications
Applying for a line of credit is similar to traditional funding, with a few exceptions:
- Financial statements: Both lenders need financial statements to see your business’s story. These are also important for you as a business owner, so you can know how much you can afford and not overextend yourself.
- Credit score: Most online lenders look beyond this. They want to see your overall business performance, not just a number.
- Connected accounts: Connecting your business accounts (like your business’s checking account, PayPal, Etsy account, etc.) can help lenders learn more about your business.