How Does a Small Business Line of Credit Work?
A line of credit is an open-ended revolving loan that a financial institution lends to a borrower as needed. Learn more about credit lines for small businesses.
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A small business line of credit (LOC) is an ongoing credit facility that allows your company to draw upon a defined amount of money for a set period. It provides you with immediate access to liquidity whenever you need funds. If, for example, your company has been hit hard by COVID-19, you may use a line of credit for liquidity. You can repay it immediately or over a specified period of time.
If you qualify for a line of credit, you will pay interest only on the funds that you pull from the account. Once you pay back the borrowed funds, you will have access to the same amount of money. It’s more like a rainy-day fund that can be utilized in hard times like during this coronavirus pandemic.
The repayment schedule for a small business line of credit varies from one lender to another. However, most lenders will require you to make payments either on a weekly or monthly basis.
Assume that a lender gives your small business a line of credit worth $10,000. That’s the maximum amount you’ll be allowed to borrow.
If you don’t withdraw any money, you won’t have to make any payments or pay any interest. That’s because you’re only required to make payments on cash that you have used (along with interest accrued on it). Therefore, the entire $10,000 will still be available for you to borrow.
However, if you withdraw $6,000, then you’ll have a $4,000 balance that you can still borrow. Your lender will start charging interest on the $6,000 as soon as you withdraw it. You can choose to repay the entire $6,000 at once or make minimum weekly/monthly payments.
Every time you make a payment, your available line of credit will increase by the same amount. Thus, if you pay $1,500 of the $6,000 debt, then you’ll be allowed to borrow up to $5,500 (4,000 plus the $1,500 that you’ve repaid).
Typically, your business will begin with a fairly low credit limit. But once you establish a good credit history with the lender, they’ll increase the available limit. Amid the current coronavirus pandemic, you can negotiate with your lender for a limit that matches your business needs.
A business line of credit is essentially a short-term credit facility. It can help your small business to meet short-term capital needs as well as finance emergencies and small investment opportunities. You can use the proceeds of a small business LOC for:
· Mitigating loss in case of an emergency situation like the coronavirus pandemic
· Paying for expenses like payroll and utility bills
· Purchasing inventory
· Repairing business equipment
· Working capital during the off-season. This may be necessary if your business is seasonal
· Funding a marketing campaign.
Generally, business credit lines tend to carry lower interest rates compared to other short-term credit facilities like business credit cards. Credit cards can charge well over 20% interest while credit lines start from as low as 3%.
What is a common interest rate for a line of credit? A rate of 3% to 10% is excellent but hard to get. Realistically, you will be looking somewhere between 10% to 99% and it can vary widely depending on a number of different factors.
That said, keep in mind that business credit lines have variable (or adjustable) interest rates. They can change from time to time depending on certain conditions. For example, your lender may slap you with a higher interest rate if you default on an overdue balance.
Small business loans carry more or less the same interest rate as small business credit lines. However, a loan is much harder to qualify for, especially if you’re a small business. That’s precisely why term loans are not dependable sources of finance for emergencies like COVID-19.
On the other hand, it’s easier to qualify for a credit line, which makes it ideal for COVID-19 mitigation. Besides, a line of credit offers a reusable fund that you can tap into whenever you need to, contrary to a loan where you get a one-off lump sum.
Thus, with the current pandemic, you can draw from a credit line for employee salaries, then later for inventory, and then for utilities and so on. This ongoing nature of a LOC gives it an edge over a term loan.
Just as important, you only pay interest on the amount of credit that you have used. In the case of a term loan, you have to pay interest whether you actually use the money or not. That makes it quite expensive for small businesses. Therefore, if you’re on a cost-saving mission – like most small businesses are in these COVID-19 days – then it makes more sense to opt for a business line of credit than a term loan.
When attempting to answer the question, “How does a line of credit work?” you must remember that it depends on the specific agreement you sign with your lender. Some of the most popular types of lines of credit include:
· Personal line of credit: this is a credit line that’s extended to an individual, not a business.
· Business line of credit: this is a facility that a business can use to expand its liquidity. A small business line of credit falls under this category.
· Home equity line of credit (HELOC): a HELOC is a line of credit that’s borrowed against the borrower’s home value. In other words, you’re required to put up your home as collateral.
· Securities-backed line of credit (SBLOC): in this case, a lender gives you a line of credit with the obligation that you put up securities that you hold in your brokerage account as collateral.
Business lines of credit are usually offered by:
· Traditional lenders like commercial banks and community banks
· Online and fintech lenders
Be sure to shop around because interest rates vary widely from one lender to another.
Oftentimes you’ll get the best business line of credit for startups and small businesses from online and fintech lenders. They have more relaxed lending terms compared to banks and other traditional lenders.
There are no hidden fees either, which makes it perfect for a small business that’s keen on saving costs. Plus, you can get an instant business line of credit provided you have a Hatch business checking account.
It’s a sharp contrast to banks and other lenders who typically only consider established businesses that have strong credit histories. Besides, they have strict lending terms.
Typically, business line of credit requirements for banks include:
· Minimum of 6 months in business
· At least $25,000 annual revenue
· Good credit score of at least 500
· Availing of business documents, including financial records, business licenses, bank statements, tax returns etc.
Therefore, if your business doesn’t meet any of the stated business line of credit requirements, you’re better off looking at alternative lenders.
As an open-ended credit arrangement, a revolving line of credit allows small businesses to borrow money, repay it, and draw upon it again. Clients can complete this cycle as many times as needed within the stated duration of the agreement. Business owners can take care of all their immediate expenses with a revolving line of credit because it provides access to funds on demand.
A non-revolving line of credit functions much differently than a revolving one. Once you borrow and pay back the entire principal to the lender, your account closes and becomes unusable. At that point, you must apply for a new line of credit.
If you’ve ever searched for ‘how does a line of credit work’ on Google, then you’ve probably come across offers for secured and unsecured lines of credit. Here’s a lowdown on each option:
A secured business line of credit requires that you put up collateral before the lender issues the credit. Examples of collateral include your home, car, or savings account. The upside is that a secured credit line often provides a higher maximum credit limit and lower interest rates.
An unsecured business line of credit is not backed by any collateral. As such, it carries a greater risk; at least from the lender’s point of view. That’s why you’ll often get a higher interest rate and lower borrowing limit compared to secured credit.
There are times when it makes a lot of sense to get a secured or unsecured business line of credit:
1. When you need to better manage your business’s cash flow. Unlike a business loan, a line of credit doesn’t limit how you can spend the proceeds. Thus, you can use it to pay for expenses like payroll or capital needs like inventory. This may be necessary in times like these when small businesses are bearing the brunt of the current pandemic.
2. When you need an ongoing line of credit. A business loan avails a one-off lump sum of cash. That’s great when you need to make a huge capital investment like purchasing a building. However, if you want a credit facility that you can tap into whenever you’re strapped for cash, then a credit line makes more sense.
3. When you need to avoid some interest. If you borrow a loan, you’ll pay interest on the full amount. With a line of credit, you only pay interest on the cash that you have actually used.
4. If your business is seasonal. A credit line could come in handy in the low season when you can’t sustain the business from pure sales.
Overall, a small business line of credit is an excellent way to stay in business when you’re struggling to raise cash. Don’t allow a lack of funds to get in the way of your business goals. A line of credit can be a great option for businesses looking to gain access to additional capital when growing.