How Business Lines Of Credit Work
If you’ve been looking for loans, there’s a pretty good chance you’ve come across the term “business line of credit.” Lines of credit are an incredibly convenient and versatile way to borrow money. Businesses looking to smooth out their cash flow, or those that want a rainy day fund to draw on, may find them particularly useful.
We’ll try to answer some of the more common questions about business lines of credit below.
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How Business Lines Of Credit Work
The easiest way to think of a business line of credit (and lines of credit in general) is like a virtual credit card. In fact, credit cards are a type of revolving line of credit.
Rather than paying out a lump sum, as they would with a loan, a lender can extend a line of credit to borrowers. The line of credit comes with a credit limit which represents the maximum amount of money you can potentially borrow on that account at any given time. You can draw on that line of credit in whatever increments you desire, so long as the total amount you’ve borrowed is less than or equal to your credit limit. If it’s a revolving line of credit (most are), the credit is reusable. So if you have, say, a credit limit of $5,000 and borrow $500, you have $4,500 remaining to draw upon. If you pay off your $500 principal, you’ll have $5,000 to draw upon again.
Well, not exactly. Lines of credit come in a variety of different forms with lots of variations in terms of their duration, grace periods, how they handle interest, draw fees (if any), and security. Most lines of credit that last longer than a year are subject to annual review. There may also be an annual fee to keep the account active.
So what is a business line of credit? Simply, it is a line of credit that is oriented toward business expenses and serves to provide a business with working capital. Like non-business lines of credit, these lines of credit can be structured in a variety of different ways. Many business lines of credit, particularly those with smaller credit limits, are unsecured, meaning that you don’t have to put up any collateral to qualify.
How Asset-Backed Business Lines Of Credit Work
Not all business lines of credit are unsecured, however. When you sign up for a line of credit, you may be asked to put up an asset as security. In the case of asset-backed lines of credit, the asset you provide as security is used to determine the amount of credit that the lender will extend you. Your credit limit will be a percentage of the value of your assets.
Acceptable assets will vary from lender to lender, but can include things like your accounts receivable, invoices, or inventory. On the surface, this may sound a little bit like invoice factoring, but there are some important differences. Whereas with invoice factoring, you’re actually selling your invoices to a factoring company in exchange for a cash advance, you still own the invoices if you use them as security for an asset-based line of credit. That means, for example, that you’ll still be responsible for collecting payments on those invoices.
If at any time the value of your collateral changes, your credit limit will likely be affected.
Why would you go for this kind of line of credit? Collateral reduces the risk to your lender which, at least theoretically, allows them to offer you better terms and rates than you’d get with an unsecured credit line.
How Interest-Only Grace Periods Work
Some lines of credit come with an interest-only grace period, notably the ever-popular home equity line of credit (HELOC). You do sometimes see them offered as perks for business lines of credit, though usually for a shorter period of time.
For the length of the specified grace period, you don’t have to pay down the principal at all if you so choose; you need only make interest payments on the amount you’ve borrowed. You’ll probably want to if you can, however, since a lower principal means lower interest payments.
In many cases, when the grace period ends, you’ll no longer be able to draw on your line of credit. At that point, it effectively functions as a loan with regular monthly principal and interest payments.
Business Lines Of Credit VS Business Term Loans
So now that you have a sense of how business lines of credit work, let’s look at how they compare to business term loans and when you might want one over the other.
Business term loans come in a number of different forms, but they all provide a lump sum up-front. You get your money, minus any origination fees, and then typically enter the repayment period immediately. Like business lines of credit, business loans are meant to be used for specific business-related expenses (inventory, working capital, etc.).
Why would you want a business loan over a business line of credit?
- They’re (usually) easier to qualify for.
- The rates can be better than a similar line of credit.
- You know exactly how much money you need.
- You want a predictable repayment schedule.
Why would you want a business line of credit over a business term loan?
- You need some “insurance” against upcoming expenses.
- You don’t know how much money you’ll need to borrow.
- You want to smooth out your company’s cash flow.
- You want flexibility.
Be sure to pick the right tool for the job.
Business Lines Of Credit VS Credit Cards
Remember when I said credit cards are a type of line of credit? That’s true, but there are some important differences between them and the kind you’d get from a lender.
Credit cards are optimized for point of sale transactions; you swipe them and, provided you have enough available credit, you’ve successfully made the purchase. What credit cards aren’t good for is getting cash into your hands when you need it. In fact, cash advance rates for credit cards are really dismal, and one of the worst ways to use your credit card. Business lines of credit, on the other hand, are a relatively inexpensive way to infuse your company with cash on short notice.
Credit cards come with an interest-free grace period every month, so a savvy credit cardholder can avoid ever paying interest on their credit card purchases. The flip side of this is that any balance you carry on your credit card will be subject to high-interest rates.
Why would you want a credit card over a business line of credit?
- You want convenience when making retail purchases.
- You want to take advantage of credit card rewards programs.
- You make purchases you can pay off quickly.
- You want the insurance perks that come with using a credit card.
Why would you want a business line of credit over a credit card?
- You need cash on demand.
- You need to carry a balance month-to-month.
- You need a higher credit limit.
Note that some lenders offer lines of credit that allow you to tap them with a credit card. Some of these products even have reward programs. Just make sure you know for sure what type of product you’re working with so you can use it optimally.
Should You Get A Business Line Of Credit?
A business line of credit offers a wealth of advantages to borrowers, but that doesn’t mean they’re a great fit for every company. Most come with costs, so you’ll probably need to do some math to determine if they’re a wise investment.
- Money When You Need It: When an unexpected expense hits you, you don’t have to search between your couch cushions for loose change or take out a high-interest short-term loan to cover the gap.
- Peace Of Mind: Having a backup account to cover expenses can do a lot to help you operate with confidence.
- More Credit For Your Effort: Since a revolving line of credit can be reused, you’re potentially getting a lot of capital for the effort you put into your application. No one wants to apply for loans more often than they have to.
- Fees: Annual fees, draw fees, and interest payments can add up over time. If you don’t see yourself using your line of credit in the near term, it may end up being an unnecessary expense.
- Easily Abused: If you’re a spendthrift, having a deep well of credit to draw from might encourage your bad habits.
- A Loan Or Credit Card Might Be A Better Option: As we touched on earlier, there might be a better tool for the job than a business line of credit. If you just need a one-time cash infusion or need to make frequent, smaller retail purchases, consider a different product.
Business lines of credit can be a great alternative to term loans if you need a more flexible product or want to have a cushion to fall back on. Think a business line of credit is what you need but aren’t sure where to look? Check out our recommended lines of credit.