The Merchant’s Guide to Line of Credit Loans
If you’re a merchant who’s struggled to pay bills or missed out on an opportunity to grow your business due to a lack of capital, you know just how frustrating cash flow problems can be.
Assuming you have half-way decent credit, and you’re willing to pay a hefty fee, there are many, many lending institutions that would love to give you money, and fast. The problem is, in situations like the ones above, a full loan is overkill. And despite the fact that many lending institutions advertise their fast funding rates, the money might not be fast enough. A regular loan will not do.
Have you considered getting a line of credit?
What is a Line of Credit?
Although lines of credit (LOC) have been around for a long time, banks and other lending institutions have recently started making greater use of the model.
Lines of credit are very similar to credit cards. When you apply for an LOC, your funder will give you access to a certain amount of money, which you can draw upon at any time. Like a credit card, you only pay interest on the capital that you’ve borrowed.
Credit cards are so similar to lines of credit, in fact, that they’re sometimes conflated: the latter is referred to as a traditional line of credit, whereas credit cards are a non-traditional line of credit. For the purposes of this article, we’re only talking about traditional lines of credit.
The difference is, LOCs tend to be less expensive than a credit card, and their repayment terms are usually different.
Let’s say you have a $25K line of credit. You borrow $5K, which means you pay interest on the $5K that you borrow, and you have $20K left to draw from. Two months later, you borrow another $5K. Now you’ve got about $10K outstanding (minus what you’ve already paid back), and you have $15K left in your line. Once you repay the outstanding balance, you’ll be able to draw from the full $25K again.
What are LOCs for?
LOCs are intended for different uses than term loans (in which you get one lump sum of money up-front). In general, LOC’s are used to cover financial gaps in day-to-day operations. LOCs are used if you need to pay bills but your commissions haven’t come through yet, if one of your ovens suddenly quits, or you need to buy more inventory because the holidays are coming.
Essentially, LOCs are primarily a financial safety net. They’re intended to make ends meet.
By contrast, term loans are used for larger, one-time projects like expanding your restaurant, opening up a second location, or buying large amounts of equipment.
The two types of capital do overlap: you can still buy seasonal merchandise with a small term loan, for example. Or you can use an LOC for larger purchases when the total cost is unknown. You don’t want to get a loan for $50K, and then only wind up using $25K, because you’d still have to pay interest on the full amount of the loan.
Essentially, with an LOC the money is there when and if you ever have the need.
Sounds pretty great, right? Now let’s talk about why you might not want one…
LOCs are not without their downsides. Before getting a line, here are the biggest potential problems to be aware of:
- Interest increases: Unlike a term loan, interest on a line of credit is not generally fixed. Those who have trouble repaying their loan might discover that their interest has increased significantly. Think of it like auto insurance: if you get into a car crash, your monthly payments are going to increase.
- Overspending: If you max out your line of credit, the money won’t be there when the need arises, defeating the purpose of the loan.
- Fees: Many funders require a monthly or yearly fee. Some also charge a fee to draw from your account, or for other reasons. OnDeck (see our review), for example, charges $20/month in maintenance fees. Annoying, but a small price to pay for financial peace of mind, in my opinion.
- Difficulties getting another loan: Depending upon your provider, an LOC could make it more difficult to get a term loan, especially if you are making repayments when you apply for another loan.
Even if you wanted to get a line, there’s one more significant problem you’ll have to overcome:
- You might not qualify: Whether it’s because your business is young, you have poor credit, or you don’t have any collateral, a line of credit can be difficult to get. Thankfully, LOCs are becoming so popular these days that many online lenders are beginning to offer them. Alternate lender’s qualifications tend to be more lax than those of banks, so merchants who can’t get a bank or SBA line of credit might be able to get one from an alternate source. Though even then, most alternate lenders require at least a fair credit score.
The Bottom Line
If your business could benefit from a financial safety net, a line of credit might be a very convenient way to overcome rough times. Older, more established businesses will have an easier time being approved, but younger businesses might be able to get one as well. A potential solution for new business owners is to get a personal line of credit that can be used for business expenses.
Due to the nature of the loan, if you’re considering a line of credit, don’t put it off. Lines of credit are only useful if you have access to one when the need arises. And as always, don’t forget to make some comparisons.
If you’re interested in a non-traditional line of credit, your next stop is our list of the best lines of credit for business owners.