Understanding A Business Line of Credit

business line of creditWhat is a Business Line of Credit?

A business line of credit is a business financing arrangement where a lender makes a pre-determined amount of capital available to a borrower to use as needed. Similar to a business credit card, a maximum limit of available credit is set for the borrower based on the lender’s guidelines and the borrower’s credit worthiness. Interest rates for business lines of credit are generally variable, at a few points over the prime rate. Much like a credit card, a line of credit provides businesses with a maximum borrowing amount.

Advantages of a Business Line of Credit

  • A line of credit for a small business is often referred to as revolving lines of credit because, when the outstanding amounts borrowed are paid-off in a timely manner, you will be able to borrow from the full amount again, without having to reapply for additional credit
  • You can borrow what you need, at a moment’s notice, up to your credit limit
  • You only pay interest on the amount you use
  • Once established, you have access to immediate funds, it’s like money in the bank

A hypothetical borrowing cycle for a business line of credit: a small business is approved for a line of credit up to $100,000 maximum limit. The business needs to purchase equipment in the amount of $10,000, so it draws that $10,000 from their line of credit. Let’s assume the repayment term is 6 months. The company has drawn $10,000 from the business line of credit and starts to accrue interest on the $10,000, and still has access to $90,000. Six weeks later the company borrows another $30,000, so its credit line is down to $60,000 and the outstanding debt (that is accruing interest) is $40,000 (less any payments). When you repay the money you owe, you will have access to the full $100,000 again.

Secured or Collateralized Lines of Credit

Some financial institutions do not require lines of credit to be backed by collateral. Also, it is important that borrowing standards at banks do have some flexibility due to competition, so if you have superb credit, you may try to push for an unsecured line of credit.

However, for small businesses with a less than perfect credit profile, a common type of line of credit is an asset-backed line of creditThese lines are backed by normal types of business revenue and assets such as unpaid invoices, inventory, and monthly recurring revenue. With an asset-backed line of credit the maximum available credit is generally correlated to the value of the company assets. There are pros and cons associated with secured lines of credit.

Because your loan is backed by collateral, these types of credit lines will likely have lower fees and lower interest rates than credit lines that aren’t backed by collateral.

Conversely, pledging your assets for this type of loan means that you cannot use them for any other valuation purposes related to borrowing.

Who Should Use a Line of Credit?

Because you do not need to reapply every time you need funds, a line of credit can be useful for a number of scenarios. If your business is in any of these situations, you may want to consider applying for a credit line:

  • Your business has inconsistent cash flow
  • You frequently need cash to capitalize on unexpected opportunities
  • You need additional capital, but you don’t know exactly how much
  • You want a financial safety net just in case the need arises
Timothy Kelly
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