A healthy cash flow is essential to any small business—access to funding for short-term needs can remove much of the stress of paying for business expansion. In these situations, one option is to use a business line of credit. These specialized financing options give your business access to a revolving loan that you can use to build out services and meet business needs.
We’ll explain what business lines of credit are, how they work, the requirements for applying, and other important things to consider.
What is a Business Line of Credit?
A line of credit is a specialized business loan. It lets you borrow money up to a certain amount on a revolving basis. This means you “draw down” (borrow) against that amount as needed, then pay back what you’ve borrowed when you can—subject to lender requirements.
One way to understand business lines of credit is to compare them to personal credit cards. You use the money when you need it, up to a credit limit, then repay that money as soon as possible to avoid being charged too much interest.
How Does a Business Line of Credit Work?
Here’s how a line of credit works in practice:
- You apply for a line of credit with a lender and get approved.
- You’re assigned a credit limit, which is the maximum amount you can borrow.
- You draw down on that credit limit according to business needs and get the funding transferred to your bank account.
- The lender charges you interest based on how much you borrow and for how long.
- You repay the credit as your business finances allow.
- Any repayment will reduce the amount of interest you need to repay.
- You continue borrowing and repaying as needed.
Why Do I Need a Business Line of Credit?
A line of credit is about providing your small business with flexibility. For example, you might use a line of credit to:
- Buy more inventory so you can prepare for seasonal trends and spikes in demand.
- Expand into a new marketplace where you can make more money.
- Repair and upgrade your business assets to enhance employee productivity.
- Fund an advertising campaign to introduce your products to a new audience sector.
- Develop new business offerings that you can sell at a profit.
It might be tempting to use a line of credit to fund shortfalls in revenue and high operational costs, but unless you deal with the root cause of those issues, you’re not going to be able to repay the line of credit quickly. That means higher interest rates, more borrowing, and greater stress.
Our general recommendation with line of credit drawdowns is to use the money you borrow to fund business expansion and increase future revenue.
What’s the Difference Between a Fixed-Term Business Loan and a Line of Credit?
A fixed-term business loan means you can borrow a certain lump sum immediately, then repay it through monthly payments over time until you’ve settled the principal you borrowed and any interest you owe. With a fixed-term loan, you pay interest on the lump sum you borrowed, plus compounded interest on that amount, over the life of the loan.
A line of credit does not provide a lump sum, you borrow only as much as you need at that moment, then repay it as soon as you can. Depending on your lender’s terms, you may need to make regular weekly or monthly payments. With a line of credit, you only pay interest on the money you borrow for as long as you borrow it.
Lines of credit often have higher interest rates than fixed-term loans and can be harder to apply for. Many lenders will also require you to bring your outstanding balance to zero at periodic times during the duration of the line of credit.
Are Lines of Credit Available as Secured or Unsecured Borrowing?
Lines of credit are often available as either secured or unsecured loans. The type of credit you get will depend on several factors:
- The lender that you start a line of credit with.
- How much you want to borrow.
- How much you can afford to repay.
- The interest rate on the line of credit.
- Whether you can provide business assets as collateral.
- Various other areas.
Secured Lines of Credit
A secured line of credit will be lent against your business assets, like equipment, inventory, property, and bank accounts. If you default on repaying the line of credit and do not meet the lender’s terms, they can seize and sell your business assets to pay off outstanding debt.
Secured lines of credit typically have lower interest rates and fees, together with less stringent repayment requirements than unsecured credit.
Unsecured Lines of Credit
An unsecured line of credit will need to be backed up by a “personal guarantee” or a “general lien.” This means if you default on repayments, a lender can seize your personal assets or general business assets, sell them, and use the proceeds to repay the debt.
Unsecured lines of credit typically have higher interest rates and fees, together with more stringent repayment requirements than secured credit.
How do I start a business line of credit?
You start a business line of credit by:
- Assessing your business needs for short-term financing.
- Establishing how much you can afford to repay on a weekly or monthly basis.
- Getting a shortlist of lenders that provide lines of credit.
- Gathering the information the lender needs to decide whether to extend credit.
- Applying for a line of credit.
- Being approved for the credit.
What Are the Typical Business Requirements for Getting a Line of Credit?
Requirements vary between lenders, but typically include:
- Your business license to operate.
- Your most recent tax returns.
- Recent bank statements for your business bank account.
- Financial reports such as your balance sheet, cash flow statement, and profit and loss.
- How long the business has been around.
- The track record of the business in generating revenue and profit.
- Your business credit score (if you do not have a business credit score, your personal credit score may be used instead).
- Whether you want a secured or unsecured line of credit.
If you can show that your business is profitable, that you’re generating good revenue, that you have good financial management, and you have a repayment plan, this will increase your chances of being approved.
Is There Anything Else I Need to Know About Business Lines of Credit?
Yes. Here are a few things to keep in mind:
- Lines of credit often have high interest rates, especially if they are unsecured.
- You may be charged a setup fee and ongoing/transaction fees for operating a line of credit.
- You should always prioritize paying off your line of credit quickly to avoid too much interest.
- Lenders will often require you to completely repay any balance and keep a zero balance for a period of time during the year.
- Lenders may require that you pay back a line of credit immediately upon their request.
Much of our advice on how to get a fixed-term loan applies to lines of credit, too.