How Does a Line of Credit Work?

Among the more popular funding options for small businesses, a line of credit can be advantageous to have…the key is to apply before you need it. That is to say, if you wait until your company is in trouble or desperate need of additional cash, you probably will not be able to qualify for a business line of credit, which is why it is important to get one while the company is in a good financial position. A line of credit works much as a business credit card would. You are approved for a set amount and you draw on this amount as you need. Consequently, you only pay interest on the money that you use — not on the total overall line amount. Unlike with a credit card, you are receiving actual cash to pay for purchases. You then pay back the line, and the money is there for you to use again. Most business lines of credit are revolving lines of credit to this end. In this article, we take a closer look at how a business line of credit works.

Some Basics Associated with Business Lines of Credit: Pros and Cons

One thing to keep in mind is that there are both secured and unsecured lines of credit. A secured line is established by pledging collateral, and because of this interest rates are lower. This is why many businesses will in fact use assets to back the line; however, if you are a newer business and don’t necessarily have collateral to put down, an unsecured line of credit is still an option.

There are times when your company’s working capital is tight. You of course rely on working capital to keep operations flowing. When you have more money going out of the business than is coming in, you may experience difficulty covering even just day to day expenses. This is where having an already established line of credit really can help you. So what might be some of the other benefits as far as having a line of credit in place…

More Money for the Slower Season

For several businesses, there are going to be times that are busier than others when sales are up and revenue is flowing in, and on the flip side, those slower seasons. Weathering these downtimes can be tricky from a cash flow perspective. If you don’t have enough coming in to say, pay employees, for example, this could present a real problem. And you can’t use a credit card to cover these kinds of expenses. So here again, is where a business line of credit can certainly save you.

Only Pay Interest On What You Borrow

Unlike with a term loan or equipment loan, with a line of credit, you only pay interest on the amount you spend, not the entire line. And with many lenders, you also have the option of paying off the line early without incurring any prepayment penalties.

Take Advantage of Opportunities

Opportunities do come up where you need to act quickly to capitalize on them. For example, let’s say there is a significant discount on supplies you need but only for a short period. Having that line already in place will thus allow you to jump on the offer and take advantage of the discount.

Helps You Build Credit

Especially if you are a newer company without a long history of creditworthiness, having a line of credit and promptly paying on it can go a long way toward establishing a credit history for the company. This way too, down the road if you go for more funding than you’ve shown you do not pose a risk and a lender is more apt to work with you. You also might be able to get better terms by paying on your line on time.

There are a few things to be careful of when it comes to applying for a line of credit. Some of the cons associated with this type of business funding…

Certain Fees Can Add Up

Yes, only paying interest as you go seems an ideal situation; however, you do want to keep in mind that there are fees associated which can add up — more so than you might think. This is why it is so important to do your homework, research lenders, ask any questions that you may have regarding any relevant fees that may be tacked on once you do have the line established.

Difficult to Qualify For

In some cases, depending on factors associated with your business, a line of credit may be harder to qualify for than some other loan products. The lender will want to see evidence of positive cash flow as well as a healthy annual revenue to ensure that you can repay the money you draw from the line. Some of what you’re probably going to have to provide include your tax returns (business and personal), bank account info, and financial statements, among other documents they might ask for. Many lenders will also require that the business is in operation for at least two years.

Using Your Line the Wrong Way

Ideally, your business line of credit will be there when you need it — so during times when cash flow isn’t where it needs to be. However, if you use it excessively and dip into that line without being strategic about it, it will not be there when you most urgently require it. Make sure you’re disciplined enough to use the line as it is intended to be used.

Smaller Amounts Than Some Other Loans

As far as borrowing amounts, a line of credit is generally lower than a term loan or an SBA loan. If you need a larger sum for an expansion project for example then getting a business line of credit may not be the best way to go. There are loan products more suited that you should look into.