What Are the Limitations of an Operating Line of Credit?

An operating line of credit is a great financial tool for effectively managing cash flow fluctuations, handling unexpected expenses in a timely manner, and ensuring that day-to-day operations are running as smoothly as possible.

However, as with every other financial tool on the market, it also comes with certain limitations alongside its benefits. As a borrower, it is important that you have a good understanding of both in order to avoid compromising the financial health of your business.

In this article, we will discuss the main limitations of an operating line of credit and why it’s important to consider them before applying for this type of loan.

What Is An Operating Line of Credit?

An operating line of credit is a financial tool that provides access to a predetermined amount of funds that can be drawn upon as needed. Its main purpose is to finance the day-to-day operational expenses of a business.

Some of its main characteristics include:

• Revolving nature – business lines of credit are revolving in nature, which means that you can borrow, repay, and re-borrow funds up to a pre-approved limit.
• Renewable – as opposed to business term loans, which are not renewable, operating lines of credit are reviewed and renewed annually by the lenders.
• Interest on drawn amount – interest is only charged on the amount drawn from the maximum limit, not on the entire credit limit approved by the lender.
• Secured or unsecured – an operating line of credit can require collateral (secured) or can be issued without collateral based on creditworthiness (unsecured).
• Quick access to funds – this financing option provides a quick access to funds, providing significant financial flexibility to the borrower.
• Variable rates – operating lines of credit come with variable rates that fluctuate with market conditions.

8 Limitations of an Operating Line of Credit

Now that you have a good idea of what a line of credit is let’s take a look at the main limitations of an operating line of credit:

1. There is a limit on the credit amount you can borrow

One of the key limitations of an operating line of credit is that there is a limit on the credit amount that you can borrow at any given time from the lender – which is predetermined based on factors such as your creditworthiness, revenue, and collateral, among others.

While the flexibility to draw funds as you need them up to the limit is one of the main advantages of this loan, it also presents a limitation in certain cases:

• May not be enough for large projects – if you need funds for undertaking a larger project, the capped amount on your credit line may not always be sufficient. For example, if you’ve been approved for $100,000 but need $120,000 for a new project, you may have to seek additional funding.
• Adjustments by lenders – since the operating line of credit is revolving, lenders may occasionally review it and adjust the limit based on the changes in the market or in the financial conditions of your business. Depending on the case, you may experience a reduction on the maximum amount, limiting operational flexibility.
• Budgeting challenges – when it comes to the limitations of an operating line of credit, you should also keep in mind that planning and budgeting is key for managing it effectively. Otherwise, you may end up exhausting your limit prematurely.

2. Secured lines of credit require collateral

Another thing that you should consider when applying for an operating line of credit is that it comes in two types: secured, which requires a collateral, and unsecured, in which the lender doesn’t require a collateral but may have stricter eligibility criteria.

When it comes to the limitations of an operating line of credit, if you go for the secured option, you will have to provide a collateral as an additional safety layer for the lender in the case of defaulting.

It can be in the form of a real estate property, accounts receivable, or another valuable asset. While collateral mitigates risk for the lender, which translates to better terms and lower interest rates for you, it also means that you risk losing it if you default on your loan.

In addition, pledging assets as collateral for a line of credit may limit your ability to use those same assets as collateral for other financing. This could affect the ability of your business to secure additional funding if needed.

3. Interest rates are often variable

Next on the list of limitations of an operating line of credit is the fact that interest rates are variable – for you as a borrower, this means that they can fluctuate over time based on market fluctuations, potentially resulting in higher costs for the business.

In other words, if the market rates increase, you may face a higher cost of borrowing, increasing the overall cost of the credit line over time.

Fortunately, variable interest rates are not necessarily a bad thing – if the market rates decrease, you can actually benefit from lower interest payments on your line of credit, potentially leading to cost savings.

These rates are typically tied to a benchmark interest rate, such as the prime rate, LIBOR (London Interbank Offered Rate), or another reference rate. When these benchmark rates change, the interest rate on the line of credit adjusts accordingly.

4. Lenders may periodically review the line of credit

Speaking of limitations of an operating line of credit, another thing that you will have to keep in mind is that lenders may periodically review your line of credit and make adjustments based on your financial health and risk profile.

These reviews are usually scheduled at regular intervals – for example, on a yearly basis. However, they can also be triggered by specific events, such as a significant change in your credit score, or a downturn on business performance.

Some possible results from the reassessment include the following:

• Adjustment of the credit limit – if the financial situation of your business has improved, you may see an increase in the credit limit. However, if your situation is riskier than before, this limit may be reduced.
• Reassessment of interest rates – another possible outcome is re-evaluation of your interest rates. If your risk profile is better than it was when you applied for the line of credit, the interest rates may reduce, but the opposite can also happen. A shift in the market interest rates may also have an impact.
• Potential termination of the credit line – during the periodical review, you will have to provide documentation to show your current financial health. If your business is in poor financial health and poses a risk that’s too high for the lender, they may terminate the line of credit altogether.

While a periodical review is among the limitations of an operating line of credit, keep in mind that you can also use it as a negotiation opportunity. Especially if your situation has improved, you may end up getting better terms and lower interest rates.

5. Poor credit management may impact credit score negatively

One thing is to get approved for an operating line of credit, and another thing is how you manage it effectively to your advantage. If you are mismanaging it, you may face another one of the limitations of an operating line of credit – a lower credit score.

In other words, if you:

• Constantly max out your line of credit
• Consistently fail to make payments on time
• Default on your line of credit
• Borrow too frequently and too substantially

It will signal to lenders that you are too reliant on your line of credit, and are unable to sustain your operations through your business cash flow, which may reduce your credit score.

On another hand, late payments or defaulting can have a severe and long-lasting impact on your score, so you want to avoid both as much as possible.

6. Qualification criteria can be difficult with a lower credit score

Qualification criteria is another factor that should be taken into consideration when it comes to the limitations of an operating line of credit – it can be more stringent than other types of loans, especially if you have a lower business or personal credit score.

Because lower credit score is associated with a higher risk for lenders, businesses may end up paying higher interest rates if they qualify for the line of credit, which increases the cost of borrowing.

Lower credit limits, stricter repayment terms (such as shorter draw periods or more frequent review cycles), as well as stricter collateral requirements are other implications of having a low credit score. You may also have to provide a personal guarantee in addition to collateral.

On the positive side, if you have a good credit score, you should have no issues qualifying whether you are applying for a secured or an unsecured line of credit.

7. The revolving debt cycle can be hard to exit

The last one of the limitations of an operating line of credit is the debt cycle – since this type of financing is revolving in nature, it implies being in a continuous pattern of borrowing, repaying, and re-borrowing funds up to the credit limit.

While exactly this flexibility is what makes the line of credit an amazing financing option for many businesses, it can be harder to exit the cycle if you are not managing it carefully. You can become too reliant on credit to manage day-to-day operations.

What Are The Benefits of an Operating Line of Credit?

Despite some possible limitations of an operating line of credit, the reality is that this financial option offers a wide variety of benefits, and it is a great tool for companies looking for extra short-term funding.

Some of its main advantages include:

• Flexibility in cash flow management, allowing you to bridge cash flow gaps
• Reduced borrowing costs as a result of only paying for what you use
• Providing a financial safety net in the case of emergencies or unexpected expenses
• The revolving nature of the credit line allow for re-borrowing funds again after paying
• Offers operational flexibility, providing funding for a variety of purposes
• Potential to improve credit score as long as you are managing it responsibly

In addition, having readily available financial resources can give your business a competitive advantage as it allows you to tap into new market opportunities and initiate new projects fast, without having to reapply for a loan.

Applying for an Operating Line of Credit

If you are planning to apply for an operating line of credit, and you are ready to take the next step, look no further than National Business Capital. With a single application, you can get access to dozens of exclusive offers from our diverse lender platform, so you can make the best decision for your business.

With $2+ billion financed since 2007, multiple awards, and an experienced team of Business Finance Advisors, we have everything you need to find the best financing options for your project.

Are you ready to get started? Apply here.