What is a business line of credit and how does it work?

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Owning a business often comes with challenges, including issues with cash flow and other unexpected hurdles. A business line of credit can cover a variety of short-term financial needs, from unexpected expenses to covering payroll and supplier fees when revenue is down. A business line of credit can help small business owners secure funds to cover immediate needs.

Business lines of credit can be established with both traditional and online lenders. Before deciding on a business line of credit, it is important to understand how they differ from traditional small business loans, and whether they are the right fit for your business.

What is a business line of credit?

A business line of credit is a flexible loan for businesses that works like a credit card. Companies draw money from their credit lines as needed, only paying interest on the portion of money borrowed. As they repay the amount borrowed, they replenish the funds available. These funds can typically be accessed using a business checking account, credit card or mobile app.

There are two types of business lines of credit you can use: secured and unsecured. These two options can vary considerably when it comes to interest rates, fees and requirements. A secured line of credit uses collateral that you own as a guarantee for your loan. If you do not repay the loan, the lender can take your collateral to help satisfy your debt. An unsecured line of credit does not use collateral, which can make it harder to obtain and more expensive to repay.

How does a business line of credit work?

Business lines of credit are similar to business credit cards, both allowing small businesses to access funds when needs arise instead of the lump sum a business loan would provide.

Interest rates on business lines of credit are typically lower than those of a business credit card. Lenders set credit limits and interest rates based on factors like how long the current owner has been in place and what the company’s annual revenue is. A line of credit typically requires renewal annually.

What are the requirements to get a business line of credit?

Typically, lenders require that you be in business for a minimum of six months before applying for a business line of credit. Lenders also want to see that you will be able to repay your loan, so they’ll usually require a minimum annual revenue of $25,000 or more, depending on the lender. The credit score requirements for a business line of credit vary based on your lender, but generally, it’s recommended that you have good credit before applying.

How is a business line of credit different from a business loan?

A business line of credit is a type of revolving credit; a business can withdraw funds whenever the need arises, as long as the credit limit isn’t exceeded. Interest then accumulates on the funds that are drawn, usually at a variable rate. For these reasons, a business line of credit can be useful for small-business owners looking to cover short-term needs.

In contrast, a small-business loan is a lump sum of money given with a fixed interest rate and paid back through fixed monthly payments. Loan payments start immediately, whether a business uses the money right away or not. Borrowing limits are often lower on a line of credit than on a business loan, typically ranging from $10,000 to $100,000. However, some lenders offer secured lines of credit, which offer higher limits of up to $3 million. Secured lines of credit require that you provide collateral.

Additionally, business loans are typically limited to predetermined uses, like purchasing new equipment, while lines of credit are more flexible, allowing you to use the money for whatever you choose.

Is a business line of credit right for me?

Your specific business needs will determine if a business line of credit is right for you. A line of credit is a good fit for businesses that:

  • Are looking for extra cash flow.
  • Don’t have a specific purpose in mind.
  • Experience seasonal fluctuations.
  • Have increased short-term expenses, like replacing inventory or paying for unexpected costs.
  • Have customers who take longer than 30 days to pay.
  • Want easy access to extra funds.

Business lines of credit offer flexibility and usually have fewer requirements than business loans.

However, keep in mind that lines of credit often come with variable interest rates, meaning that the rate you’re given initially may rise over the course of your repayment. There are also usually fees that can quickly add up, costing you more than you may have initially expected. These lines of credit can also be much harder to qualify for. Lenders often restrict the amount that you can borrow, generally allowing smaller amounts than the typical business loan.

Where can I get a business line of credit?

Business lines of credit are available from banks, credit unions and online lenders. When comparing options for a business line of credit, look at loan amounts, interest rates, loan terms and lending fees. Online lenders may be more forgiving of low credit scores, but they may also have lower limits for loan amounts.

To qualify for a business line of credit, you’ll likely be asked to provide documentation such as personal tax returns, business tax returns, bank account information and business registration documents.

What are the interest rates on business lines of credit?

The interest rates on business lines of credit can fluctuate significantly depending on market conditions and the lender you choose. The typical interest rate for a business line of credit can begin as low as 5 percent but also run more than 20 percent. This variability only reinforces the need to shop and compare lenders for the lowest interest rate on your business line of credit.

How do you use your business line of credit?

Once your business credit line is approved, you can start drawing from your credit line, withdrawing as much as you want up to your limit. Every month, you’ll have to make a minimum monthly payment on your business line of credit. Once you repay the amount you’ve drawn from your credit line plus any interest you’ve accrued, those funds will once again be available for you to use.

While your line of credit offers flexible spending, get in the habit of using it only when needed. Limit usage to short-term expenses, paying used funds in full as quickly as possible. Paying off your line of credit quickly promotes responsible use, builds up your business’s credit and could lead to better financing options later. It also decreases the amount of interest you’ll pay on the funds you borrow.

The bottom line

A business line of credit may be just the thing to provide your company with the necessary cash flow to meet short-term needs. It’s more flexible than a small-business loan and offers higher limits and lower rates than most business credit cards.

Take time to evaluate your specific business needs to determine if a business line of credit is right for you. Make sure to read the fine print to check for any hidden fees and verify that your business meets the requirements for a new line of credit.

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