Do I Need a Line of Credit for My Small Business?
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If your business is profitable, do you need a line of credit?
In this post, we explore this and other questions around lines of credit and see why businesses without cash flow issues keep a line of credit (LOC) available.
A business credit line is a low-cost way to get short-term financing to help cover working capital needs. Keeping a line of credit open can come in handy for expansion and growth opportunities.
How Does a Business Line of Credit Work?
A business line of credit is sometimes referred to as a revolving line of credit or a LOC. Similar to a credit card, you apply for a line of credit. This type of loan allows you to draw out funds from your credit line, pay it down or pay it back, and re-access it. A line of credit enables you to decide if, when, and how to use the borrowed funds. With access to a business line of credit, a small business can weather the fluctuations, seasonality, and economic changes in business revenue and expenses.
Interest is usually charged only on the borrowed amount; interest rates may be variable or fixed. Some lenders may charge a "withdrawal fee" per transaction.
Typically, there is a specific repayment period; payments vary based on the amount of outstanding funds. Traditional banks may offer a "draw period" during which you can access funds and make interest-only payments. At the end of that period, you can pay back the principal or negotiate a repayment period with your lender to pay back the balance.
Online lenders offer short-term LOCs, to be paid back in 6 to 24 months.
How a Line of Credit Can Benefit Small Business Owners
Here are some examples of how your small business may benefit from a line of credit:
- If you own a seasonal business, it can fluctuate—a small business line of credit can help cover expenses during low-sales periods.
- You have some loyal customers that are slow-payers—but the rent won't wait. You may need a line of credit to cover expenses while you wait for those payments.
- You have an opportunity to impress a new client, who can help grow your business, and you need capital to bridge the gap and cover the increase in supplies and labor. A line of credit will help cover those expenses until you get this client's account producing revenue.
- An opportunity arises to purchase inventory or equipment at a significantly reduced cost—an LOC can cover the expense until your cash flow catches up.
Numerous other situations may justify a personal line of credit as well.
Qualifying for a Line of Credit
There are several lender types to choose from when applying for a line of credit:
- An online lender
- An online marketplace (where you can shop various lenders)
- Business loan broker
- Through a bank
- Through a credit union
What Lenders will Evaluate:
- Amount of time in business: 2+ years is ideal
- Credit scores 600–650+: Lender requirements vary, and some banks may require higher scores.
- Lenders will verify revenues via financial statements, tax returns, bank statements.
- Without a business bank account, it is more difficult to qualify
- Most lenders do not lend to unincorporated businesses—consider incorporating as an LLC, C Corp, or S Corp
What are Secured vs. Unsecured Risks?
Most small business lines of credit are unsecured—the lender has not requested any collateral, considers you low-risk, and trusts you to pay the loan accordingly.
One of the most fundamental rules is: Don't borrow against your line of credit just because it's there.
If you have a budget, follow it; if your income is stable, avoid the urge to tap into your credit line to splurge on a cruise, new furniture, a wedding, or your kid's college. Instead, consider applying for a zero-interest introductory rate credit card--but only if you have the means and a solid strategy to pay it off within the intro period.
For a secured line of credit, you put up collateral whose value matches the loan amount — jewelry, your home, stock portfolio, gold— and usually come out ahead with an even lower interest rate. However, the risk here is even more significant--mismanagement of the LOC will cause you to lose your property.
Pros and Cons of a Business Line of Credit
Lenders are more likely to qualify you for a business line of credit when your business is healthy with no cash flow issues. It's difficult to qualify when your business is in a cash flow crunch. If you are approved for a line of credit now, you are under no obligation to use it right away.
Some lenders charge an origination fee, and/or an annual fee, and/or a monthly maintenance fee if you don't use your line of credit. Be sure to read and understand the terms offered and any fees they may charge you.
A small business line of credit can be helpful to most business owners. But if you need money to fund a one-time or long-term project, a small business loan might work better for you.
When you accept a line of credit, it appears on your credit reports. If you borrow a high percentage against your credit line, which could increase your credit utilization rate, your credit scores may be affected.
As with any other form of debt, lines of credit have inherent risks. The most considerable and most often encountered risk is mismanagement of credit. Borrow wisely.
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