How a Business Line of Credit Works

If you own a business, you already know the importance of maintaining your cash flow no matter what stage your business is in. Understanding all of your funding options is crucial, so that when your business requires an influx of cash, you can make the best decision possible. Below, we’ll cover everything you need to know about business lines of credit and how they work.

A business line of credit provides a business with funding that can be used for any expense they choose, from equipment purchases to office space. While they may seem less common than loans or credit cards, according to FitSmallBusiness, nearly half (47%) of small businesses have opened a line of credit. 

What’s the Difference Between a Business Line of Credit and a Business Credit Card?

While business lines of credit and business credit cards are similar, they aren’t the same. With a line of credit, you have a draw period, or a specific number of years that you can tap into the funds. A business credit card, like a line of credit, has a maximum limit, but does not have a draw period, so you can maintain your account for as long as you’d like.

However, unlike a business credit card, a business line of credit is revolving. This means that you can use the funds up to the approved limit and, once you pay it off, you’re able to begin taking out money again. Some lenders charge a draw fee each time you access the credit line, and while APRs can be high, you only pay interest on the funds you use — this is a huge plus and can save you quite a bit in interest compared to other financing methods like a loan.

In addition, the repayment schedule varies by lender, but is typically weekly or monthly. Business lines of credit are offered through many traditional financial institutions like banks and credit unions, but are also available through some online lenders. Many business lines of credit limits are also higher than those of credit cards, which can be an advantage if you’re seeking funding for a larger expense. A business line of credit can also cover expenses that might not be as easy to charge on a credit card, like rent or payroll costs.

This option also differs from a personal line of credit in that it’s connected to your company rather than you as an individual. This can be a positive or negative depending on how long your business has been running and your financial history, as you’ll need to show proof of strong revenue and business credit history in many cases, which is often tough for businesses that are just getting started.

There are two types of credit lines: secured and unsecured (sometimes referred to as non-secured). A secured credit line requires collateral — like a home — to guarantee it, whereas an unsecured line does not. While the approval criteria for unsecured lines of credit may be more stringent since it’s a riskier proposition for the lender, most business owners prefer this option for the obvious reason that there are no assets at stake. If you end up defaulting on a secured line of credit or are delinquent on your payments after a period of time specified by your lender, they may take ownership of the collateral and liquidate it to handle the balance owed.

How Much Money Can I Access and How Do I Qualify for a Business Line of Credit?

To determine how much money you may be able to access for your business through a line of credit, you can start by taking your estimated annual gross revenue and divide it by 365 to figure out your daily cash need. Then, total your number of accounts receivable and inventory days on hand, and subtract your accounts payable days on hand to get your usage. Finally, multiply this number by your daily cash need to get an estimated line of credit maximum.

While requirements differ by lender, you usually need to be in business for at least six months, have at least $25,000 in annual revenue, and have a minimum business credit score of 500 to qualify. You’ll also need to provide documentation that may include financial statements like balance sheets and tax returns.

Pros and Cons of a Business Line of Credit

Business lines of credit come with both pros and cons, like any financing option.

Pros

• Flexibility: One big advantage is that you have quite a bit of flexibility in terms of access and use: a line of credit is revolving, meaning that once you access the maximum amount you’ve qualified for and repay it, you’re able to begin taking out money again right away. And unlike traditional financing options like a loan, you don’t necessarily have to specify what you plan to put the funding toward when you apply for a line of credit.
• Cash Flow Maintenance: A business line of credit can also help you maintain a healthy cash flow and timely payment of your bills, especially if you opt for automatic payments, which can lead to discounts from the lender. With the ability to take out as much money as you want up to the maximum amount, as often as you’d like, it helps you avoid the risks of overspending with a lump sum. This can be more advantageous than receiving a single payment for some companies as well, especially if your needs are spread out over a longer period of time. For example, if you’re planning a lengthy construction or renovation project where you’ll need more infusions of cash at different points, a line of credit might make more sense than a one-time loan.
• Future Financing Needs: A business line of credit can be a good way to grow and build a solid credit history for future financing needs as well, as many lenders require substantial financial records and credit history in order to approve you for loans and refinances. If you’re careful and responsible with it, the line of credit could actually help you increase your business credit score over time. And if you repay the amount you owe before the end of your draw period, you most likely won’t have to deal with any fees or penalties. 

Cons

• Costs: The biggest con of business lines of credit is that they can be quite expensive, with APRs as high as 10-20%, plus other fees. These can vary widely by lender, so it can pay off (literally) to thoroughly research your options before choosing one. If it’s an unsecured line of credit, it will likely have a variable interest rate, which means monthly payments can change unpredictably month to month.
• Challenging application process: The application process for a line of credit tends to be quite restrictive and demanding, with a typical credit score requirement of 600 at minimum — though it’s recommended that you shoot for an even higher score to increase your chances of approval. 
• Potential for quick debt accumulation: You have the potential to go into debt more quickly with a business line of credit than other funding sources, as the interest will compound onto the new principal amount if you miss even one monthly payment. The flexibility to take out as much cash as you want can also lead to trouble when you don’t keep an eye on your spending. In extreme cases, if you’ve ended up using the entire amount you qualified for and run into an unexpectedly slow period of low cash flow, you might find yourself unable to pay back the money — so it’s critical to first consider why you’re seeking funding and whether a one-time lump sum payment would be a better match. 

With an unsecured line of credit, it’s also recommended that you pay down your balance to zero several times during your term, which can be a hassle for some businesses. Business lines of credit are often a good choice if you are seeking a short-term financing solution — for example, you need to pay for a new piece of equipment, buying extra inventory in anticipation of a busy sales period, or hiring additional employees as you scale rapidly. Given the high fees and risks of debt that come along with business credit lines, it may not necessarily be a great fit if you are looking for a long-term and consistent funding source, simply because of the variable interest rates and potential for missed payments to add up quickly. 

Who Offers Business Lines of Credit?

You can find business lines of credit through most traditional financing providers, like banks and credit unions. However, they can have very specific minimum requirements and rigid qualification criteria, so it may be worth exploring offerings from alternative online lenders, whose processes may be faster and less restrictive. While it depends on the specific provider, banks generally want to see at least three years of revenue and strong financial records in order to qualify applicants. On the other hand, while online lenders may be more lenient, their fees can be much higher than those of traditional financial institutions and the repayment periods tend to be shorter, from 6 to 24 months.

If you don’t think a business line of credit makes sense for your funding needs, there are other financing avenues to consider as well, many of which involve using your home equity toward your business. While it does add some level of personal liability, it can often be easier to qualify for a personal line of credit, especially if your company is fairly new and doesn’t have a substantial track record in terms of statements and credit history that most lenders require.

Home equity loan

With a home equity loan, you’re using your home as collateral and borrowing against the equity you’ve built up in your home. There’s a flexible repayment period that ranges from 5 to 30 years, and unlike a line of credit, it doesn’t matter whether or not you pay the balance down to zero every year. But while these loans have fixed interest rates and predictable, consistent monthly payments (a plus for business owners), you are taking on a second mortgage with this option, meaning you’ll have another monthly payment to worry about. The application and approval process can prove difficult depending on lenders’ specific requirements, too.

Home equity line of credit (HELOC)

Similar to a business line of credit but using your home equity as a source of cash, a HELOC can also give you on-demand access to cash. The application and approval processes are often less restrictive than those of a loan, but like a loan, the interest that you pay on the money may be tax deductible. Repayment terms are fairly long, ranging from 15 to 20 years.

But also just like a business line of credit, home equity lines of credit have variable interest rates which means that your payments may fluctuate drastically every month. Your lender also has the ability to freeze your HELOC at any time if your credit score or home value drops too low.

Cash-out refinance

A cash-out refinance — which replaces your original mortgage with one that has a larger balance than what you owe and gives you the difference in cash — can provide you with funding for your business, and it can also help you to lock in a lower interest rate on your mortgage. However, because you’re basically paying off your previous mortgage with your current one, your timeline will be lengthened and you’ll have to pay application, closing, origination, and possibly even appraisal fees.

Home equity investment

A home equity investment gives you cash in exchange for a share of your home’s future value. There’s no interest or monthly payments to worry about, and like a line of credit, you’re free to use the money as you wish for anything your business needs: equipment and supplies, marketing, hiring, or office space. Plus, this option lets you maintain critical cash flow to keep your company running smoothly. You have 10 years to settle the Investment through a refinance, buyout with savings, home sale, or loan, and there aren’t any fees or penalties for settling the Investment early.

If you’re looking for a funding option for your business that doesn’t come along with the stress of interest or monthly payments, a Hometap Investment might make sense.

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