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Business Line of Credit: How Does it Work?

By Nick Zaryzcki on December 6, 2019

A business line of credit is a lot like a credit card for your business. You only pay interest on the money you take out of it, it’s usually cheaper than getting a loan, and it’s less nerve-wracking than financing your business expenses with actual credit cards.

But how exactly does a ‘line of credit’ work? Here’s everything you need to know.

What is a business line of credit?

A business line of credit (also sometimes called a revolving line of credit) is an amount of money—usually provided by a bank or credit card institution—that you can draw from to make business expenses.

Unlike a loan, you only pay interest on the cash you end up drawing from the line of credit. You don’t pay interest on the money you leave in the fund unspent. Unlike a loan, a line of credit also usually stays open indefinitely, allowing the business owner to draw from it as needed without reapplying for more financing.

How does a business line of credit work?

When you open a line of credit, your bank or credit card company will usually start sending you a monthly statement showing how much money you’ve drawn so far, the interest rate you’ll be paying, and your borrowing limit. (The typical small business line of credit limit usually tops out at around $100,000 USD.)

As you draw money from the fund, this statement will be updated to show your repayment terms. You’ll usually have to start making weekly or monthly payments to repay what you borrowed, plus interest.

Your institution might also charge you an up-front fee to set up the line of credit, an annual fee, and transaction fees depending on how often you access the line of credit.

Secured vs. unsecured lines of credit

A secured line of credit requires that you put down some collateral. This usually takes the form of short term assets like accounts receivable, inventory, securities or cash equivalents. If you can’t pay back the money you borrow, your creditor can take these away from you to make up for the lost money.

An unsecured line of credit doesn’t require you to put up any collateral. However, it might require the institution to put a general lien on your assets, which gives them the right to seize all of your assets if things go south.

Pay attention to what kind of credit line your financial institution is offering you, and be wary of which assets you’re signing away when signing a credit line agreement. If a financial institution asks you to fill out a UCC-1 Financing Statement, have a lawyer look over the terms of the credit line agreement first. Signing over all of your assets is a big decision.

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Business line of credit vs. loan

The difference between a business line of credit and a typical small business loan boils down to flexibility.

Loans are best for large, lump sum investments in new equipment, real estate, inventory, or other single, expensive assets. They usually have higher interest rates, are more expensive because you pay interest on the whole thing, and they usually require that you secure them with some kind of personal guarantee or collateral.

A business line of credit, on the other hand, is more about cash flow than about investing. Lines of credit are more flexible, allowing you to use as much or as little cash as you’d like. Many businesses that open them never end up using them. Having a line of credit open gives you some financial slack. If you run into a rough patch, you can draw from the line of credit instead of selling assets your business needs.

Business line of credit Small business loan
Perfect for… Day-to-day expenses Big one-time expenses
Cost Less expensive More expensive
Risk Lower risk Higher risk
Credit score needed Usually higher Usually lower

Why do people get business lines of credit?

Like any other form of business credit, most business owners will take out a line of credit to finance some kind of growth.

They might do so to make small, short-term investments—to finance an expansion in inventory, for example. They might do so to pay for an increase in operational expenses, like a new marketing campaign, a new employee, or supplies.

Some financial advisors will tell you that the best time to apply for one is actually when things are going well, when your business doesn’t necessarily need the money. It’s much easier to qualify for one when business is good and when your credit score is high.

Ideally, a line of credit should be something you already have when something unpredictable happens to your business, and not something you apply for last-minute.

How to get a business line of credit

If you’ve got your bookkeeping in order, have financial statements for at least the last two years of business operations on hand, and have an established credit history, applying for a business line of credit is fairly straightforward.

What to prepare before applying for a business line of credit:

  1. Look up your business credit score with all the major credit bureaus and make sure there are no red flags.

  2. Make sure your bookkeeping is up to date

  3. Produce a full set of financial statements for your business (including, at the very least: a balance sheet, income statement and cash flow statement).

What a bank or online lender are most likely to look at when you apply:

  • How long you’ve been in business (usually the minimum is two years)

  • Your annual revenue and profits

  • How liquid your business is, based on various credit ratios

  • Your ability to put up collateral

  • Your credit ratings (personal and business)

  • Your professional resume (i.e. how much industry experience do you have?)

The best business line of credit

You have three main options: a big bank, an online lender, and the SBA.

Banks are the least risky lender. They’re harder to qualify for, but they don’t require you to put up collateral to secure the line of credit.

Online lenders are easy to qualify for (you can do it all online) and they generally offer higher credit limits. The downside: you usually have to put some collateral on the line.

If you have poor credit, you might be able to get an SBA line of credit, if you put up some collateral.

Further reading: The Best Business Lines of Credit (2019 Comparison)

What are the downsides of getting a business line of credit?

Opening a small line of credit is a lot like getting a credit card—getting one, putting all your expenses on it and then simply making the minimum payments isn’t going to cut it. You should only open one if your business is growing and if you already have a clear path to profitability.

The biggest risk of getting a line of credit is that your business becomes dependent on it. If that happens and your creditor decides to pull the plug, you could find yourself in hot water.

Of course, the other downside is you’re paying interest on every dollar you spend. If there’s a way to wait and save your money instead, that’s always the cheaper route. But sometimes you have to spend money to get money (and sometimes you just need some cash to pay the bills).

Should you get a business line of credit?

If you’re looking for a flexible, relatively inexpensive way of financing occasional day-to-day expenses for your growing business, a business line of credit is the way to go. But if your business is in trouble and you have no clear path to profitability, relying on a line of credit could get you in trouble, and you should look at other financing options.

If you’re thinking of applying for one, get your business’ bookkeeping and recordkeeping up to date, double check your business credit score, and consider signing up for a bookkeeping service like Bench. We’ll get your books up to date, and produce all the financial statements you need.

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This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

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