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Line of Credit – When you need working capital

What is a Business Line of Credit and how can it help my business?

 

A business line of credit is quite similar to personal lines of credit like credit cards. The financial institution grants you access to a specific amount of financing. However, you don’t make payments or incur any interest until you tap into those funds.

A business line of credit’s primary purpose is to help finance ongoing operating expenses and provide a cash cushion when you need it. The best time to apply for a business line of credit is actually before you need it. A business line of credit is best for short-term financing needs, such as payroll, seasonal expenses or temporary cash flow shortages. However, don’t tie up your line of credit paying for long-term financing needs. This means you wouldn’t have access to it in an emergency—which is one of the biggest benefits of a business line of credit. This is one of the biggest issues banks have with giving lines of credit. 

A business line of credit can be either unsecured or secured (typically by inventory, receivables or other collateral). Lines of credit are often referred to as “revolving,” which means you can tap into them again and again. For instance, if you were given access to a $100,000 line of credit and you decide to take out $30,000, you will still have access to the remaining $70,000 if needed. If you pay that $30,000 back down to $0, you will then have access to the entire $100,000 without reapplying. Not having to reapply is one of the biggest benefits of a line of credit.

Most lines of credit also have renewal periods from 1 year to 3 year. Businesses look at this time to see if you have “rested” there line of credit. As stated above a line of credit is used for working capital and short term purchases. At renewal they look to see if you balance was at $0.00 for a certain timer period usually 15 to 30 days. If not, it is possible they the bank will “term out” our loan which means they will close the line and turn what you owe into a fixed loan with fixed payments and you will loose the flexibility you used to enjoy.

Business lines of credit usually have lower interest rates than traditional business loans. But, if you’re late with a payment or go over your limit, your interest rate could increase substantially. This is quite different than a term loan, where the interest rate stays the same for the life of the loan.

Business Line of Credit vs. Credit Card:

1. Credit cards usually have higher interest rates.

2. Credit cards charge additional fees for cash advances.

3. Credit cards typically require payments on a monthly basis, whereas a business line of credit typically does not require monthly payments.

Cost

Let’s use the following example: it’s time to pay bills, but you’ve yet to receive payment from your own customers for services provided, making it harder for you to pay what you owe. This isn’t the first time this has happened, unfortunately. You calculate that having a financial cushion of some amount (for our example, lets say $25,000) would help prevent this problem in the future. So, you reach out to an online financial institution and apply to open a business credit line up to $25,000. The institution grants you the requested credit line. Next time it’s time to pay your bills (and you’re still waiting on that cash from your customers), you draw out funds on that credit line.

Let’s say you needed $5,000 to cover those bills, so you pull $5,000 out of your business line of credit. Even though you have a $25,000 line of credit, you will only need to pay back the $5,000 you borrowed, plus any applicable interest. Keep in mind, though, that the interest is only charged on the $5,000 that was borrowed, not the full $25,000 you have access to. If the interest is 11% that means you would need to pay back $5550 (or $5,000 plus $550 in interest). Once that is paid, you can continue to make additional draws up to the $25,000, and only pay interest on what you are borrowing at any given time.

Who Qualifies

Many businesses can qualify for a business line of credit but it will be difficult for less-established businesses to qualify (usually under 2 years). The maximum amount available, duration of the credit line, and the repayment terms depend on your business, revenues, credit rating, and many other factors.

Types of Collateral commonly used

There are many ways to collateralize a line of credit. The most common is using your Accounts Receivable from your line of credit. Banks will ask for a Accounts Receivable Aging report which will show your accounts and how they are paying you.

Inventory is also used as collateral. Banks will require an inventory list as well.

Unfortunately a bank will not lend you 100% of what you have in Accounts Receivables or Inventory, usually banks will lend a portion of that since both can be liquidated quickly.

Advantages

  • Only pay interest on funds drawn.
  • Money is available when needed.
  • Suitable for a wide range of business purposes.
  • Excellent way to build your credit score.

Disadvantages

  • Could tie up credit, preventing you from applying for other loans.
  • May need to provide updated documents often
  • Usually require collateral.