A small business line of credit is a standard product offered by many financial institutions such as banks, credit unions, and institutional investment firms. Lines of credit can be a convenient and flexible method of financing for your small business. They provide you with access to cash and can allow a you to work around the cash flow ups and downs often experienced in the early days of a young company.
Lines of credit can also be used to accommodate any seasonal credit demands your small business might face. They provide the opportunity to purchase additional inventory as needed and to take advantage of short-term offers such as equipment sales. Lines of credit typically have lower interest rates than credit cards, which in many cases can make them a better option for short-term financing.
How a Business Line of Credit Works
With a revolving line of credit, your business gains immediate access to funds and may be able to avoid the lengthy process of applying for a business loan. Typically, banks will make a specified maximum amount of money available to a business. You can then draw on these funds (up to the maximum) and repay them as needed within the agreed upon time frame, which most often does not exceed one year. You typically pay interest on the outstanding principle balance only, not on funds that are left unused. As you pay the borrowed amount back, the funds are made available for you to use again.
Most banks offer both unsecured and secured lines of credit. For a secured line of credit, the specified maximum amount is determined by the worth of whatever collateral has been used to secure the loan. In an unsecured line of credit, it is determined by your business’s financial position and ability to repay, as determined by the bank.
Being Approved for a Business Line of Credit
Secured lines of credit may be available to most startup ventures. Personal assets of the owner may be used as collateral, such as a second mortgage on a home. Assignments of stocks and bonds may also be used as collateral, as well as the assignment of the cash value of life insurance policies.
Ideally, you want to avoid mixing your personal and business credit, because securing a loan with personal assets puts them in potential jeopardy. You may be able to get a line of credit for a smaller amount and either avoid using personal assets or at least use fewer of them.
Unsecured lines of credit are most often approved for well-established businesses that have been open for at least two years and can provide proof that the business is financially stable and healthy. You must provide the bank with financial documents that follow the standard accounting practices. Banks examine financial statements in order to ascertain what the business’s capital position is, whether there is a positive monthly cash flow, and if there are multiple sources of repayment. The business’s checking account may also be examined for a consistent average balance on a monthly basis.
Business credit is also used as a determining factor in a loan application. Business credit takes into account all other loans your business has applied for and whether the loans were approved or denied.
Business Loan vs. Credit Line vs. Credit Card
Why choose a line of credit over a loan or a credit card? A line of credit usually has a lower interest rate than a credit card, and if you can’t pay your balance in full each month, that lower interest rate is especially attractive. Getting a loan can be harder than getting a line of credit, although your ability to get either could be affected by your business credit. Loans are typically taken in larger amounts of money than lines of credit, and are usually meant as long-term solutions or for a single large purchase. Lines of credit more often serve as an “always available short-term solution,” generally for helping businesses manage their cash flow.
In many ways, a line of credit might be worth considering for a small business. But when in need of longer-term financing, such as to fulfill an ongoing contract, hire more employees, or expand the business, lines of credit may be inferior to a bank loan. Learn more about different types of funding – traditional, alternative, crowdfunding, and more – and which one may be best for your business needs.
You Might Want a Line of Credit If …
While lines of credit can be beneficial to all small businesses, there are some companies in particular that may benefit from this form of financing. You may want to consider a line of credit if you:
- Are a seasonal business
- Are looking to expand your business
- Are starting a new marketing campaign
- Need new equipment or need repairs
- Want to remodel your storefront or website
- Need to purchase more inventory
How to Prepare for a Line of Credit
To put yourself in a strong position when applying for a line of credit, make sure you prepare ahead of time. Here are some ways to get ready:
1. Establish your business credit early on and maintain it
If you apply for an unsecured (no collateral) line of credit, your rates and terms will likely be based on your business credit, so it’s in your best interest to build and monitor your business credit file. When lenders look at your scores and ratings, your efforts can help make sure they see signs of a strong, reliable business.
2. Compare institutions and rates
Different banks and credit unions may offer different rates and terms on their lines of credit. Be sure to do your research before applying!
3. Manage your cash flow and keep it positive
Try to avoid cash flow crunches by managing your cash flow and keeping your balances positive. While you may be applying for a line of credit to help you with your cash flow, you should still be able to demonstrate a positive cash flow, especially if you are trying to get an unsecured line of credit.
4. Add to your business savings
You still have to pay a monthly balance with a line of credit, as you would with a credit card. To help make sure you can pay back what you borrow, try to build up your savings before you apply for financing.
5. Think and plan ahead
It’s better to apply for any type of funding well before you need the money. So think and plan ahead for when you may need a line of credit: applying when you have positive cash flow may help you get better terms.
Not sure if a line of credit is right for your business? Explore different funding options.