Business owners need cash to fund operations and expand, but not every business generates enough cash flow to cover expenses. Financing helps cover the difference, and a business line of credit is a popular choice for small businesses that need more capital.
It’s good to understand the business line of credit requirements before you get one to fund your small business investments. That way, you will know what to expect when you apply and how to use a business line of credit to your advantage for expenses, inventory or other business needs.
What Is a Business Line of Credit and How Does It Work?
A small business line of credit works, in many ways, like a credit card. Having one provides access to money when you need it for all kinds of business expenses. Most business owners use their line of credit for short-term funding and then pay it back quickly, so the funds are there when needed again. Unlike a small business loan, where you pay interest on the entire loan over its term, with a business line of credit, you pay interest only on the amount of money you use. In addition, you can draw on the credit line as often as you need to up to the limit agreed upon when you apply, as long as you continue to make payments on time.
You can get a business line of credit from traditional banks, credit unions, and online lenders. There are fees when you apply and use your line of credit, and you will pay interest on the amount you draw from your credit line.
Qualifications, credit limits and interest rates will vary depending on the lender. Some banks and other financial institutions have stricter requirements, such as a higher credit score and minimum years in business, to qualify for this type of financing. On the other hand, online lenders may offer faster approvals and fewer fees. In addition, online lenders may make your business line of credit available to you just a few days after you apply.
If you’re wondering why you would choose a business line of credit over a business credit card, there are a few things to consider. It is possible to qualify for a higher credit limit with a business line of credit, and when you draw on it, you’ll have cash in your bank account. You can get a cash advance with a business credit card, but the fees are often higher, and you’ll pay higher interest rates, too. Business credit cards have rewards programs, but lines of credit are better if you need access to cash.
Business lines of credit usually come in two types—a secured line of credit and an unsecured one. A secured line of credit will require that you offer collateral the lender can claim if you don’t repay what you borrow. On the other hand, an unsecured line of credit won’t require collateral. In that case, the lender could require a personal guarantee. That means if your business can’t make payments on an unsecured business line, you would become personally responsible for repaying the debt.
Cons Of a Business Line of Credit
While it’s a convenient way to get cash to cover expenses, there are some downsides to a business line of credit.
No Grace Period
You immediately owe interest on a business line of credit once you borrow against it. Most credit cards provide a short grace period where you can repay debt without incurring interest. You won’t have this flexibility with a business line of credit. But, you won’t have to repay the line of credit right away and can make weekly or monthly payments depending on the schedule you agree to with the lender.
Higher Interest Rates
A business line of credit typically has a higher interest rate. You can use the lump sum right away or only borrow against the credit line when it is convenient for your company. Still, the high-interest rate can add up if you let unpaid debt linger, especially since credit lines have variable rates.
Variable interest rates change based on the market interest rate that the Federal Reserve controls. Each time the Fed raises the federal funds rate, variable interest rates also go up. While variable rates are favorable when interest rates fall, they are not helpful during economic cycles with interest rate hikes.
Pros of a Business Line of Credit
Business credit lines have some disadvantages, but they also have many benefits. So consider the positives of a business line of credit, too.
You can get a business line of credit quickly. Most lenders give you the cash on the next business day after you get approved. When you pay off the money you borrow, your line of credit remains available to you to use for your company’s needs. Unlike a business term loan, you won’t have to reapply to continue using funds. With a small business loan, you would have to apply for another loan to get additional capital.
Business Credit Building
A business line of credit gives you the opportunity to improve your credit score by establishing a good payment history and a healthy credit utilization ratio. Your payment history will be reported to the major credit bureaus. A good track record helps you qualify for better financing in the future. The credit utilization ratio measures the percentage of the money you have borrowed against the line of credit. For example, if you have borrowed $30,000 from a $100,000 line of credit, you have a 30% credit utilization ratio. It’s best to keep your credit utilization ratio at 30% or lower, but if you need the additional funds to maintain operations or grow your business, don’t let the credit utilization ratio stop you.
You Only Pay for What You Borrow
Some business owners take out business loans and borrow more than they need. These small business owners will have extra cash sitting on the sidelines, but they will pay interest on that money. You don’t have to worry about paying more interest than necessary with a line of credit. Borrowers only pay interest when they borrow money against the line of credit. So you could treat your line of credit like an insurance policy and only draw from it if you need to fill urgent gaps in your financing.
Business Credit Lines Are Reusable
Do you plan on borrowing against your entire credit line and then paying it back? If you repay the line of credit and decide you need additional funds, you won’t have to worry. You can borrow from that same line of credit without the trouble of applying for another loan. Each loan application involves fees, time, and other variables. A secured or unsecured business line of credit helps you avoid those fees and the extra hassle involved with getting another loan.
Unsecured business lines of credit do not require you to tie any collateral to your company’s financing. As a result, these loans present less downside if you can’t make on-time payments, but you may have to provide a personal guarantee that you can repay the loan.
Get Better Loans in the Future
We have already established how a business line of credit can improve your credit score and help you qualify for better loans in the future. When you make on-time payments and build your credit score, you’ll qualify for lower interest rates and higher loan amounts in the future. However, business lines of credit have an additional advantage. When you take out a line of credit and repay it, you are building a relationship with your lender. That lender will learn to trust you over time as you consistently make on-time payments. Lenders will perceive you as a less risky borrower the next time you ask for a loan.
Business Line of Credit Requirements
When deciding which lender to use, consider the bank, credit union, or online lender business line of credit requirements. Each could require different information. Lenders have different criteria by which they rate your creditworthiness. Typically, they’ll review some combination of the following:
- Personal and Business Credit Scores. If your business is relatively new, you may not have a business credit score, which will be acceptable to most lenders. However, lenders will review your personal credit score and may expect your credit score to be above 660 or 680 for you to qualify for lower interest rates and other favorable loan terms. If your credit score is low, take steps to improve it by reviewing your credit report, paying bills on time, and monitoring how much credit you have.
- Business Financials. Prospective lenders will review the annual or monthly revenue of your business. Be sure you provide the details requested in your financial statements, including your balance sheet, annual revenue and cash flow. As with other requirements, different lenders will have varied expectations for revenue. Online lenders may expect revenues above $25,000, while major banks and other traditional lenders may require revenues of $100,000 or even more.
- How Long You Have Been in Business. Lenders will consider how well-established your business is before extending a line of credit. For example, you may be required to have been in business for at least six months or even two years before some lenders will approve your application. Online lenders may put less emphasis on this requirement than traditional banks and credit unions.
- Business Debts. Lenders will need to know how much debt your business already has before offering you more debt with a business line of credit. They want to make sure you can keep up with your current obligations and maintain the payment schedule for your line of credit.
- Collateral to Secure the Loan. Not all lenders require you to supply collateral to secure the loan. Collateral is an asset you own that will become the possession of the bank or online lender if you are unable to make payments. Acceptable collateral may include business assets, such as real estate, vehicles, inventory, customer invoices, or business equipment. Offering collateral can help you secure lower interest rates since the risk shifts from the lender to you and your business.
- Industry. Lenders may consider how saturated the market is for your industry before extending a business line of credit to you. Be prepared to show a competitive analysis of how your business compares to other companies in your industry.
When you begin considering a business line of credit, gathering this information before you begin applying can streamline the process.