Should I Take Out A Business Line of Credit?

Extensive research has proven that small businesses, particularly new and growing concerns, often spur the most consistent growth to the economy. 

Unfortunately, since the 2000s decline in economic activity, banks and traditional lenders have been steering away from small businesses, instead favoring larger, more established firms. 

There are still many different ways that small business owners can obtain financing for their operational needs, however. 

One of the lesser known of these is the business line of credit.

What Is a Business Line of Credit?

A business line of credit is a specific amount of money that a business can access as needed and then repay either immediately, or over a specific period of time.

Much like credit cards, business lines of credit are considered “revolving credit”.

Revolving credit, unlike traditional installment loans such as auto loans or mortgage notes, provides access to a pre-set amount of funds during either a specified period of time, or indefinitely. 

Once a lender approves a line of credit for a specific amount, a business can draw from it up to that limit and, once they pay it back, can draw from it again. 

With this type of account, the borrower only pays interest on what they use from the credit line. 

This often makes it more cost-effective and flexible than installment loans.

There are three main types of revolving credit:

• short-term revolving lines of credit
• medium-term revolving lines of credit
• traditional bank lines of credit

With short- and medium-term revolving lines of credit, the line is only available for a certain period of time, during which businesses can draw from and repay as needed. 

A traditional bank line of credit, on the other hand, allows indefinite access to the funds.

All three function in essentially the same way and all can be secured or unsecured by collateral.

Unsecured vs. Secured Lines Of Credit

Understanding the difference between secured and unsecured loans is an essential step before applying for or accepting a credit line.

Simply put, unsecured loans are those that do not require borrowers to put up guarantees of payment (collateral), while secured loans are those that do. 

Collateral can consist of anything of value that a borrower pledges to the bank as a guarantee they will pay back the loan and can be anything such as property, cars, equipment, or even invoices. 

In the event that a borrower defaults on the loan, the lender can seize the collateral to make up for their losses.

For businesses which do not have enough assets to put up as collateral, another option is a personal guarantee from the business owner. 

With a personal guarantee, an owner would sign a legal agreement promising to pay back the loan personally if the business cannot pay it back.

For banks, secured loans – those guaranteed with some type of collateral – involve the least amount of risk and, in return, they will offer lower interest rates. 

Additionally, because banks consider it a safer option, they are much easier to qualify for. 

Unsecured loans, on the other hand, are considered riskier and will often offer much higher interest rates, making them more expensive for the borrower. 

They are also harder to qualify for, especially for businesses who do not have a long track record.

So, while secured loans are the most cost-efficient option, it’s essential that you make sure you can really repay that line of credit on time, since being late or defaulting can carry much greater consequences than with an unsecured loan.

How Business Lines of Credit Work

Variable cash flow is a factor for all businesses regardless of size, and is considered a leading cause of new business failure. 

Business lines of credit provide flexible, revolving capital in a way that regular business loans don't. 

And, unlike a credit card, these lines of credit will give you cash or checks which you can then use as needed. 

In many cases, businesses can access their funds in as little as 24 hours after approval, making it a good option for urgent cash needs.

As with every other financial product, it’s important to look at the fine print before committing. 

Lines of credit usually include clauses and covenants, that is, specific requirements the business must meet in order to keep the line of credit open. 

These covenants serve to mitigate the bank’s risk, therefore, making them more likely to extend the loan, but it can add significant burdens to the borrower. 

Breaking these agreements can give the bank the right to increase interest rates or to collect the amount due immediately, thereby closing the line of credit.

These covenants could involve:

• Net worth covenant: Some lenders will require that the business maintains a minimum level of net worth in order to keep the line.
• Monthly certification: Some lenders will establish a monthly certification process where a company will need to submit the current status of accounts and inventory in order to access the funds.
• Confession of judgment clause: If the borrower were to default on the loan, this allows the bank to file a judgment against the business without the need to go through a trial and obtain a court judgment.
• Liquidity covenant: This might make it necessary for companies to provide evidence of liquidity ratios, including current ratio, quick ratio, and the cash conversion cycle in order to keep their line of credit.
• Debt ratio covenant: This establishes a preferred ratio of income to debt that the business must maintain throughout the life of the credit line.
• Material changes clause: This clause can include a wide array of events that could have a negative impact on the business’ performance.

When Business Lines of Credit Make Sense

Lines of credit address the fact that most lenders aren't willing to give out loans every couple of months, particularly ones that are unsecured, but businesses may need periodic infusions of cash. 

Business lines of credit serve to smooth out the inconsistencies many small businesses have in monthly income versus expenses, and to finance projects in which it may be difficult to ascertain the amount of upfront funds necessary. 

They can help manage cash flow, purchase inventory, and pay for unexpected expenses.

If you and your business have solid credit, a good revenue history, and have been operating for at least six months to a year, a business line of credit can be a great choice for obtaining financing quickly and inexpensively. 

This type of debt instrument can even improve your credit score, provided you make payments on time and keep a low balance. 

This consistency gives you the opportunity to build yourself into a reliable borrower.

Since funds can be accessed instantly once approved, lines of credit are available immediately for any unforeseen emergency. 

Having one as backup, even when rarely used, can provide enormous peace of mind. 

As long as business owners take care to not tie these funds up in long-term investments, and remain diligent in their payment schedules, lines of credit are excellent resources.

Business Lines of Credit vs. Business Credit Cards: Is There a Difference?

Two popular ways for small businesses to obtain quick access to funds is through lines of credit or credit cards. 

Both are usually easier to qualify for than traditional loans. 

This is especially true for young or small companies. 

Since business lines of credit and business credit cards work in almost exactly the same way, let's focus, rather, on the differences between them.

Business Credit Cards

Though credit cards are very widely accepted forms of payment, interest rates can be a lot higher than for a term loan. 

These can be avoided, however, by always paying statement balances in full. 

One advantage of credit cards over lines of credit is that you can obtain rewards for your business spending in the form of points, miles, and cash back. 

In fact, business credit cards will likely offer bonus rewards for the types of purchases companies most make, such as telecommunications service providers or advertisers.

On the other hand, cash advances can be prohibitively expensive. 

This can be an issue, since not all billers accept credit payments. 

Additionally, approvals are also heavily tied to a borrower’s personal credit score, so it may be difficult to gain approval or higher limits.

Business Lines of Credit

These can be great tools when providers don't accept credit cards, as they can be used to access both checks and cash. 

Payments are interest-only, and there are no fees for cash advances. 

Since it relies mainly on your business' credit, it can be a good way to build a strong credit profile for your company. 

Interest rates can be substantially lower than for a business credit card, repayment can also be more flexible, and they may have less associated fees and charges. 

Though some lenders assess a maintenance fee for unused lines, many don't.

One disadvantage to a business line of credit as compared with credit cards, is the fact that they don't accumulate bonus points or rewards.

It may also require collateral, depending on the lender.

Pros and Cons of Credit Lines

Just like any other debt instrument, credit lines can be both advantageous and risky. 

Their supreme flexibility can make it easy for business owners to undertake one without fully understanding their company's opportunities or ability to repay the borrowed sums. 

Borrowers in need of large sums of money for longer time periods, for instance, would be better served by a small business loan.

Who Qualifies for a Business Line of Credit?

When it comes to business lines of credit, banks consider many of the same factors that they consider when issuing personal loans: ability to pay, income, available collateral, and credit history.

Traditional, bank-issued business lines of credit call for a substantial amount of documentation in order to qualify, such as financials, personal tax returns, business tax returns, bank account information, and business registration documents. 

Additionally, unless the business has a long history of profits, they will often request forward-looking (pro forma) cash flow statements that demonstrate an ability to pay back the money. 

Their interest rates are competitive, at between 5% and 13%.

Non-traditional financiers, such as online lenders, generally have less stringent qualifying requirements, quicker approval times, and greater flexibility. 

Online lenders tend to be substantially more expensive than traditional ones, with APRs around 20%-40%. 

They generally don't need collateral, as opposed to banks, which ask for either hard assets or short-term sources, such as receivables.

Some bankers and online lenders who participate in the SBA 7(a) loan program also offer SBA CAPLines, credit lines which have limits of $5 million and correspondingly high requirements.

Requirements: Banks vs. Online Lenders (numbers are estimates, and can vary according to individual lenders)

Independently of the lender you choose, there are a few things you can do to help your chances. 

Try and apply when your credit score is high and while revenues are up. 

If you already have a credit line, whenever you've met a benchmark for credit score, gross revenues, or time in business, it's a good time to apply for an upgrade. 

Lastly, another good idea is applying in advance of when you anticipate a capital need. 

Though it may seem counterintuitive to apply for money when it's not needed, this may be the precise time to think strategically.

WHAT IF I’M NOT APPROVED FOR A LINE OF CREDIT?

If your business does not meet the qualifications above or you’ve determined that the risks and fine print involved far outweigh the benefits, there are plenty of other financing avenues for your small business. 

Our list of top ten small business lenders is a great place to start looking for alternatives, which can include invoice financing, equipment loans, and loans sponsored by the federal Small Business Administration.