June 18, 2020

How Does Business Line of Credit Work?

Business Finances

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Business Line of Credit

Running a business is encompassed by many steps and a lot of hard work. You need to come up with an idea for the business you are passionate about, but you must then find a way to make the business happen logistically.

Using a business line of credit can be one method of obtaining funding for your new venture, and can also be a valuable tool. Lines of credit will allow you to feel secure in business and ensure you have the resources you need for your business to operate. 

Essentially, a business line of credit will allow you to obtain capital either for your business' current needs, or needs in the future. They can help your business move into the next stage of growth, help dig your business out of a situation, or bridge the gap between the slow and high season. 

What Is a Business Line of Credit?

Also known as a LOC, a business line of credit is a revolving loan. This loan allows access to a specific amount of capital that comes in handy when needed. Primarily, a business line of credit is a short term financing needs that will offer a necessary monetary return. These short term financing needs might include purchasing inventory, financing for a marketing campaign, emergency repairs, or supporting your business through a low season. 

Two Types of Business LOCs:

  • Secured Business Line of Credit:

Typically, the business or business owner should offer specific assets in return for the line of credit as collateral. Lines of credit are known as short-term liabilities, which means that lenders are often short-term assets as collateral, such as inventory. 

With a secured line of credit, lenders do not typically ask for real property as a method to obtain the credit. If the borrower cannot pay back the LOC, the lender will take ownership of the collateral. 

Secured lines of credit are known for being accessible to newer businesses, or those with lower credit profiles, but are also known for lower interest rates.

  • Unsecured Business Line of Credit: 

This type of LOC also does not require specified assets as collateral, but typically a general lien and personal guarantee will be placed on the business. 

To obtain an unsecured line of credit, the business or business owner will usually need to have a strong credit profile as well as a favorable business track record, which can make it difficult for new companies to obtain an unsecured LOC. 

Additionally, interest rates may be slightly higher than a secured line, and unsecured credit lines are often in smaller amounts than secured lines. 

When Should I Consider a Line Of Credit?

There are many reasons why your business might benefit from a line of credit. Whether your business is going through a difficult time or looking for access to short-term funds, applying for a line of credit might be a good idea. 

Instances your business might benefit from a LOC:

  • If you are a seasonal business that generates most of your income in one particular season of the year. For example, if you are a water sports business in New Jersey, you might use a line of credit in the winter to help cover any overhead between operational seasons.
  • For a small business to develop a marketing campaign. Although you may not have the capital to exercise this size of a campaign, a line of credit can help you attract new business and expand. It would not take long for borrowed funds to get paid off because you will quickly generate revenue.
  • If your business needs to cover expenses while waiting for client invoices. Although not favorable, this can often happen, and having cash on hand can ensure you do not miss payments. 

How Does a Business Line Of Credit Work?

When opening a business line of credit, your business will receive a specified amount of funds. These funds get used when needed, and you will receive a monthly statement regarding balance and interest. 

One significant aspect of a credit line is that you will only pay interest on the funds you use, versus the entire agreed-upon amount, such as with a term loan. After repaying the amount used, the credit limit is always accessible again. 

When you are required to pay your line of credit is dependant on your lender, which can be either weekly or monthly. Lines of credit often carry annual fees in addition to interest charges. If you use your LOC often, you may also get charged a transaction fee.

Lines of credit are small when they are under $100,000. These small lines of credit can are similar to using a credit card. You can choose to access your funds in a few ways from these types of accounts by,

  • Tying a credit card to the line of credit, 
  • Writing checks from the account,
  • Depositing funds directly into your business bank account with an ACH deposit.

These methods give you the freedom to use your funds; however, you need whether that means fulfilling purchase orders, hiring catering for a fundraising event, or paying your staff through a slow period.

What is the Difference Between a Term Loan and a Line Of Credit?

When looking for financing, many lenders offer both a line of credit and a business term loan. These are two completely different forms of financing. 

Being evaluated for a term loan is more about how your credit profile looks in the moment while being evaluated for a line of credit is more about the future, which is why the process for a line of credit is more detailed and intense. 

Another significant difference between a term loan and line of credit is regarding the funds. Term loans offer a specific amount of funds given at the time of approval. The payments are typically paid over a set term for a particular schedule until the balance gets repaid. 

With a line of credit, there's more flexibility. You may borrow from your credit limit whenever you need to do so, and borrow again, which is usually allowed over a specific amount of time. It typically needs to be paid off during the term of the credit line. 

The bottom line is that rather than being used for long term needs, such as with a term loan, LOCs are for short-term purposes. 

Where to Obtain a Line of Credit

When looking for a line of credit, you can usually go to any major bank.  Including community banks, commercial banks, and even credit unions. Online lenders, such as Divvy, offer business lines of credit with great terms.

How to Apply

When looking to apply for a line of credit, it is very similar to applying for a term loan. You should expect that most lenders will want to see your financial records and other documents that show a strong business financial track record. You should be able to offer documentation that helps you appear trustworthy and able to pay back the loan.

If you plan to go through a traditional lender, such as a bank or credit union, you should expect them to request more documentation than an online lender. Request the necessary documents before your first meeting.

You must be able to discuss the financial position of your business. If need be, consult your accountant or a financial advisor beforehand. You do not want any surprises regarding your business's financial status when you meet with the banker.

Bring the following information:

  • Your business license
  • Three months of bank statements
  • Tax returns
  • Proof of your business bank account
  • Financial documents, such as P&L, AR, AP, Cash Flow, etc.

Be prepared to prove:

  • That your business is profitable and able to generate new revenue,
  • You or your management can understand the financial side of running a business,
  • Your business plan for the line of credit, including the specific expenses you are looking to cover, and your ability to meet payments. 

Expect to be rejected for a LOC if your business is:

  • A company or start-up still within the "idea stage."
  • Looking to cover your losses on past operations
  • Needing capital to meet immediate expenses that do not guarantee profits

What Should I Know Before Opening a LOC

Before opening a LOC, it is essential to know your lender's qualification criteria, conditions of the loan, interest rates, and fees.

You should ask many questions when opening a LOC. Find out if there are charges for account set-up, transactions, or annual fees. Often there are no annual fees for the first 12 months, but there will be a fee on the 13th month. 

Ask if you need to pay down your LOC balance to $0 at any point in the year. Often, a lender will require this to be done and maintained for at least 30 days, assuring that the business is profitable aside from the LOC and not entirely relying on it.

Your lender might place a clause in your contract that gives them the right to declare the LOC payable immediately at any time. Meaning your full balance would have to be paid entirely without any warning. Failure to pay back the line of credit could result in penalties. Still, if your business depends on the LOC, you could be in danger, so it is imperative to gain all of the necessary information before signing.

Is It Easy to Obtain a Line of Credit?

If you have decided you want to apply for a line of credit, be aware that there are a few requirements to be accepted. 

Lenders generally look to offer a credit line to establish businesses and businesses with a good credit record. Typically a new company without a history of business credit will have a difficult time acquiring a line of credit. The same goes for business owners with a low personal credit score. 

One good rule to go by is that lenders will look to offer LOCs to businesses that have established history for over two years. If you find it challenging to obtain a line of credit due to being a new business, look into a secured line of credit.

Secured lines of credit are usually backed by the Small Business Administration, and offer four different options to help finance new small businesses. 

How to Stay on Top Of Your LOC

  • Never let your balance build dramatically to the point of nearing your credit limit. Instead, periodically pay down your balance. Helping you stay in control and show your lender that you are trustworthy. 
  • Do not use a line of credit to cover losses. As it will make it incredibly difficult to repay and may put you in a worse situation than when you applied for the LOC.
  • Consider your timing for when you apply for a line of credit. The best time to apply for a LOC is when you have proof of actual cash flow.

Keep Your Business Running Smoothly

Using a business line of credit can be a fantastic tool to grow your business and generate profit. Not only does a LOC offer your business the chance to bridge the gap for seasonal businesses, but it can also be incredible for taking the next step of growth. 

As with any type of financing, the most important thing to consider is making sure that you can repay any financing amount loaned. Maintaining a line of credit in good standing can help build your credit profile, and qualify you for better financing in the future. 

Keep your business running smoothly with a line of credit. Utilize it's worth, pay it off, and grow your business.