Being a business owner, one should have quick access to capital. It’s a given that some businesses struggle with consistent and reliable cash flow. Unexpected circumstances like sales slowdown, expensive equipment, and delayed payments hinder constant cash flow. Hence, companies need cash to solve these unexpected hurdles and keep the bankruptcy risk at bay.
How is the business line of credit beneficial to small companies?
Companies can establish a LOC or line of credit using both online and traditional lenders. Before diving into this type of credit, it is also essential to understand how it differs from the conventional business loan and whether the LOC is ideal for your business.
What does a business line of credit mean?
Think of how a credit card works, and you will understand the business line of credit. Companies basically draw money from their credit line when needed and only the interest on the part of the money borrowed. As borrowers repay the money borrowed, they immediately replenish the available funds. Borrowers can access these funds using either a credit card, a mobile application, or a business checking account.
To put this into context, a bank lends your business a line of credit of $40,000. You then withdraw $10,000 to purchase inventory. All you need to pay for now is the interest on the $10,000. You can also freely use the remaining $30,000 credit as the need arises. If your business needs another $5,000 for new equipment purchases, you can immediately withdraw the money before paying back the $10,000. Lenders will only charge interest on the amount your company borrowed.
Secured vs. Unsecured business lines of credit
Companies can use two kinds of LOC – secured and unsecured. These two options vary depending on interest rates, requirements, and fees.
Secured Business LOC
When borrowers opt for the secured business line of credit, lenders will need specific assets that will serve as collateral to ensure the credit or the line. Since it’s a short-term liability, most lenders will require short-term assets like inventory and accounts receivable. Also, lenders will most likely not require capital assets like equipment or real property to get a LOC. If borrowers fail to repay the credit, the lender will assume ownership of the agreed collateral and liquidate it to settle the balance.
Unsecured Business LOC
Choosing an unsecured LOC means lenders do not require borrowers’ specified assets as collateral. Instead, there must be a personal guarantee or a general lien on the credit agreement. Since there is no collateral involved, the business needs to have a solid credit profile and a good track record. The interest rates on this credit line are slightly higher, and the amount involved can be smaller.
How does the credit line work?
Once the business decides to avail and open a credit line, it receives access to an agreed amount stated on the contract. Companies can use the funds as needed. The monthly billing statement mainly includes the amount of credit used for the period and interest charges. Besides interest fees, annual fees for the line of credit are also standard. And if your business constantly uses the LOC, lenders might also apply transaction fees.
The payment and the interest are based on the funds used for a specific period. Once the borrower repays the credit used, it will automatically replenish the available funds. Also, the payment schedules vary depending on the lender. Repayments can be on a weekly, monthly, or periodic basis.
When should a business apply for a line of credit?
Suppose your business regularly needs easy fund access to cater to short-term capital requirements, then applying for a business line of credit might be a good idea. What could be the possible scenarios where a company needs the business LOC? See the list below:
- A seasonal business can use a line of credit to help cover the overhead while bridging from one season to the next. The LOC allows companies in this kind of business to keep normal business processes and operations despite the income fluctuation.
- Small businesses can also utilize LOC to finance marketing campaigns, boost possible new customers, and expand sales. There is a higher probability that companies can pay off the credit quickly as the campaigns can positively generate additional revenue.
- While waiting for client invoice payments, a business can use LOC for cash management to cover the necessary expenses.
Essential points to know before applying for a line of credit.
A lender will set qualifications to be agreed upon in every credit or loan before enforcing the contract. As a borrower, it is essential to be familiar with the loan conditions, qualification criteria, interest rates, and fees.
- The credit line might involve charges for setting up an account and annual and transaction fees. For example, a bank or a lender may charge a $150-dollar opening fee without a yearly fee for the first twelve months but will have an annual fee at the start of the second year of the agreement.
- In some cases, lenders might require borrowers to pay off their outstanding balance to $0, usually for at least 30 days. This is the lenders’ way to reduce risk and assure that borrowers generate sufficient cash flow.
- The unpredictable nature of every market might also force lenders to let borrowers pay off the credit immediately. This means they need to pay the total balance amount and reduce the LOC to zero. This can be a significant predicament if one’s business relies heavily on LOC.
While terms and conditions vary from lender to lender, those mentioned above are common scenarios that borrowers must consider.
Applying for a LOC
Like term loans, lenders will look for financial documents and records demonstrating an excellent track record and creditworthiness. Traditional lenders like credit unions and banks might want to require additional documentation. This is typically in contrast to online lenders, which might require fewer documents. It is essential to know the possible requirements before visiting a lender. Here are some of the crucial information a borrower needs when applying for a LOC:
- Tax returns
- Business license
- Business bank account
- Bank statements for 2-3 months
- Necessary financial documents profit & loss, accounts payable and receivables, and cash flow, among others
There might be unfamiliar documents that lenders might require from borrowers in some cases. In this case, it is ideal for them to consult an advisor or a CPA. This way, they can better explain how the documents affect the financial health of the borrower’s business.
Generally, lenders rarely offer lines of credit to:
- Startups or idea stage businesses
- Cover losses on past initiatives and operations
- Meet urgent expenses that will not significantly bring profits
To show that your business is an ideal prospect for a LOC approval, be ready to present the following:
- The management understands all the financial aspects of doing business
- The borrower’s business has the potential of generating additional revenues
- The business has a concrete plan for the line of credit covering particular expenses at specific times.
- It is capable of meeting periodic payments.
Using a line of credit allows using the funds however the business sees fit. It can cover current business costs or cash flow gaps or take advantage of unexpected challenges or opportunities. With a LOC, one needs not to have certain use cases outlined to apply and secure the cash.
Unlike term loans, where one needs to take out a lump sum to make regular payments, businesses can use lines of credit as required. Borrowers will only repay as they use the funds and only pay interest on the funds drawn.
In some cases, lenders will accept LOC even from those with bad credit history. However, the rates and terms might not be very ideal. This makes the line of credit an excellent alternative to traditional loans. A LOC can also be a perfect way to improve credit history.
Most lines of credit have lower interest rates than short-term loans. However, you should also know that the rate will vary based on your annual revenue, credit score, and other important financial factors.
The pay-as-you-go mechanic of a LOC is ideal. However, the fees can add up immediately. It will still vary from one lender to another, and the agreement terms. Ultimately, it pays to research possible lenders offering a LOC and compares them. With this, you can find the right LOC provider for your business.
It can be hard to qualify for
Some lenders might require you to submit several financial documents proving your business is worthy of the line of credit. These include personal and business tax returns, checking and bank accounts information, and business planning papers.
In some cases, lenders will impose a yearly review to maintain the borrower’s credit line. Also, some lenders require every borrower to have at least two years of business history to qualify for a LOC.
A potential risk for misuse
The line of credit for your business serves as an insurance policy during shortages in cash flows. It is to be used as needed. Beyond these scenarios leads to a higher probability of a disaster. For most, it is a real temptation. The LOC might not be beneficial for businesses with a significant amount of debt, or you aren’t capable of repaying your balance.
Low borrowing limit
Suppose you need more significant cash for your business; a LOC might not be for you. Lines of credit generally come in a relatively low borrowing amount. For project expansion, purchasing new equipment, or other expensive business expenses, it can be ideal for you to opt for another financing service.
Ready to apply for business LOC? Here are some valuable tips for keeping your line of credit:
- Avoid making your average balance near the credit limit.
- Religiously repay your balance.
- Securing a line of credit to cover business losses is not an ideal option as it can make the repayment difficult.
- Strategically think about the capital needs for the whole year to identify the right time to apply for a LOC. Almost all lenders approve a line of credit applications when businesses show a strong cash flow.
Is a line of credit the same as a small business loan?
Indeed, a line of credit and a small business loan are the same in that they are both financing services that businesses can use. However, they differ in their process. A small business loan involves a lump sum of money with a fixed interest rate and monthly repayments. Meanwhile, a LOC allows businesses to withdraw funds as needed.
Can my business qualify even if it hasn’t been operating for long?
Yes. However, lenders and banks typically prefer businesses with at least two years in business operations. Suppose you are a startup company; lenders might need a personal guarantee and some personal collateral to qualify.
Is it difficult to get a line of credit for my business?
It will depend on several factors. This includes the length of the business operation, your credit score, financial statements, and cash flow, among others. If your business has been operating for several years, you will most likely qualify for a LOC. It can be a handful to get credit approval if you are a startup.
Which lender is best for a business LOC?
The best lender will depend on every business applying for a LOC. In applying for lines of credit, there are online lenders like Booster Financial, credit unions, and banks to choose from. Credit unions and banks require solid business revenue and minimum years of business history to qualify. Meanwhile, online lenders have fewer qualifications but might impose higher interest rates.
When is the line of credit a good idea?
A business LOC is most beneficial when one needs financing on short-term business expenses like inventory or covering unforeseen costs. It can also be a solid start to building an excellent business credit score.
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