This post was last updated on March 10, 2021 with more information about how business lines of credit work.
Wondering how does a business line of credit work? If you’re the owner of a fast-paced business that faces unexpected challenges and opportunities on a regular basis, there’s a good chance you’ve heard of or been recommended to acquire a business line of credit. But what exactly does the term “business line of credit” mean? How does it work, and what can you use it for?
Read on to learn the answers to all these questions and more about how this flexible financing option works!
What Is a Business Line of Credit?
A business line of credit is a type of loan for business owners that allows them to draw cash as they need it to cover expenses, and only pay interest on what they take. These lines of credit are provided by lenders including banks, direct lenders, and other alternative business financing companies. Typically, revolving lines of credit also allow the borrower to draw cash as they pay their balance down.
A business line of credit operates similarly to lines of credit required for personal use. The borrower gets access to a credit limit to withdraw from, either all at once or in increments as needed.
This withdrawal limit is determined by many factors, including the qualification standards set by the lender who provides you with your credit line, as well as your business’s annual gross sales, your FICO score, and the total amount of time your business has been active.
Different lenders will have varying requirements. For many small businesses, meeting the qualifications at a bank or through the SBA can be difficult due to strict credit qualifications. Anything else on your credit history, like a tax lien, can also limit your chances with a traditional lender.
On the other hand, fintechs and alternative lenders are known to be more lenient.
How Does a Business Line of Credit Work?
A business line of credit gives you, the business owner, access to cash that can be withdrawn as needed. Instead of paying interest on the full approval amount, you only pay interest on the amount you borrow.
The amount of funds you can withdraw is called your credit limit. The credit limit you’re approved for is determined by the lender who reviews your financials, and is based on a few factors.
With a credit line, there’s no need to withdraw the full amount of your credit limit all at once. You can borrow a portion for a specific expense, and save the rest for another time.
The primary benefit of a business line of credit, compared to other options, is that it offers financial flexibility. You’ll be in a position to cover unexpected expenses and take charge of new opportunities as they arise, instead of waiting weeks for a loan approval or for cash flow to improve.
Many small business owners go through the process of getting approved for a business line of credit as a precaution. Should you encounter unanticipated opportunities, expenses, or challenges, you’ll be able to deal with them quickly and efficiently by simply withdrawing money from your small business line.
What Is a Business Line of Credit For?
With a small business line of credit, you’ll be able to finance ongoing expenses as well as one-off purchases. You could even use your reservoir of funds to pursue new opportunities for growth.
Many entrepreneurs will use a business line of credit as they grow and expand. For example, a line of credit can be invaluable as you open a new location, invest in additional inventory, finance marketing campaigns, and more.
A business line of credit can also be used as an emergency fund. Because you don’t start paying interest until you start using your line of credit, it can be a great resource for covering cash flow gaps or other unexpected expenses.
How Interest Rates & Payments Work
The interest rates, payment schedule, and other terms on your business line of credit will vary according to the lender and your unique financial situation.
Generally speaking, interest rates on a line of credit are usually lower than credit card interest rates. They are also fixed, meaning it’s unlikely they’ll increase.
When signing your agreement and withdrawing funds, your payment schedule will be decided by the lender. Some lenders will insist you make payments on a monthly, bi-monthly, weekly, or daily basis. While paying on a daily basis means frequent withdrawals, this also means lower payment amounts—which can be helpful as you manage working capital.
If you choose to borrow the full credit line in a lump sum, then you’ll simply pay interest on the full amount.
Lenders typically view shorter repayment terms as less risky. If your credit score and financials aren’t sound, you may have to accept a shorter payment term in order to qualify.
Top 3 Advantages of a Business Line of Credit
There are several advantages to having a business line of credit that no other financing option can provide. Here are the top 3 ways business lines of credit help business owners accomplish their funding goals faster and easier:
- Your company can have a steady flow of cash during periods of lower revenue.Let’s say that you own a retail store that is seasonal. Most of your sales may come during the holidays or over the summer. Other times of the year, your business may be short on cash, making it challenging to pay employees.In these cases, a business line of credit provides a fast and simple way to bridge gaps in cash flow, and keep your operations running smoothly. This is an important part of how a business line of credit works, and a crucial advantage offered by this product.
- It helps your business take advantage of opportunities faster.For example: a manufacturer is informed the prices provided by his or her supplier will drop for a limited time. The manufacturer will want to purchase products at a discount. However, at the time, he or she may not have the available capital to do so.By opening a business line of credit, they minimize the likelihood of missing such a great opportunity.
- You can bolster the credit history of your business.
By maintaining a line of credit that’s in good standing, you may be able to increase your business’ credit rating. The better your rating, the better the loan terms for which you will qualify. This is especially important if you have a need for future financing.
Types of Business Credit Lines
There are many types of business lines of credit available for business owners, including:
- Secured Business Lines of Credit: Credit lines that are leveraged by assets held as collateral by the business owner. The reduced “risk” lenders take on due to securing their capital typically results in terms that are more desirable for the business owner.
- Unsecured Business Lines of Credit: A credit line that does not require collateral in order to get approved. Through certain alternative financing companies, these can come with terms that are just as desirable (if not more) than secured business credit lines.
- Revolving Business Lines of Credit: A credit line with “revolving” terms, meaning a business owner can replace any amount of funds they withdraw back into their credit line, where it will become immediately available to use again.
Each type of credit line comes with unique terms that help business owners meet their unique goals in different ways.
When considering using a business line of credit to fund your business, make sure you explore all your options in order to find the financing option that best fits your specific needs.
Business Line of Credit Vs. Small Business Loan
So, how does a business line of credit differ from a small business loan? There are a couple of key differences between the two, which can help you determine the right option for you.
A small business loan provides borrowers with a lump sum of cash they pay back over time with interest. On the other hand, a business line of credit provides continuous access to working capital, which you can draw from whenever you need.
A small business loan is ideal for major one-off purchases or expenses, like opening a new location or offering a new product or service. Many small business owners will also use a loan to take on additional customers, projects or clients.
A business line of credit is more flexible than a small business loan. Because you can draw cash at a moment’s notice, they make covering new expenses a simple process. Many lines of credit are also revolving, giving you the freedom to draw more cash as you pay it down.
Some business loans, especially through banks, limit your usage of loan funds to specific purposes. Alternative lenders like National don’t have the same restrictions—both loans and lines of credit can be put toward any expenses.
Credit Cards Vs. Business Lines of Credit
A business line of credit has more in common with a business credit card than other forms of financing. Still, there are some differences between the two.
Credit cards tend to have higher interest rates and lower credit limits than a business line of credit. Typically, they’re used for transactions, rather than direct access to cash. Accessing cash can involve paying expensive fees, meaning that it’s not a sustainable or cost-effective way to draw cash.
While credit cards do have the unique benefit of rewards programs, business lines of credit are often still cheaper due to lower interest rates.
Many small business owners are most comfortable with using credit cards for everyday purchases. However, for larger financing projects and ongoing expenses, a business line of credit works best.
How to Apply
At National, we made the business credit line application process as simple and speedy as possible for you.
All you have to do is fill out our simple 1-minute application online. When the application is completed, a Business Financing Advisor will contact you in minutes to learn more about your business, answer your questions, and help you find the best financing option for you.
You could receive an approval in less than 24 hours!
Apply now to get started!