Cash flow is the lifeblood for small businesses. Yet, cash shortages are hard to avoid. Late or missed client payments, large influx of orders, unexpected disasters, or big unplanned expenses can all be devastating for small business owners.
A business line of credit can help you weather any storm of business expenses that arises. It can also provide a valuable safety net in the event of an unexpected shortage in capital, or provide you with the means to take advantage of a surprise growth opportunity.
But what is a line of credit, how is it different to a business loan, and how can you use it? In this post, we’ll answer:
* What is a line of credit?
* How is a line of credit different from a business loan?
* Are there any fees associated with a line of credit?
* Do lines of credit require a personal credit check?
* How do I apply for a small business line of credit?
* What interest rates can I expect?
What is a line of credit?
A line of credit is a pre-agreed amount of money that you can borrow from your bank when you need it and repay back when you don’t. Unlike a loan, the money can be used as and when you need it for things such as one-time purchases or expenses. The credit line is repaid at any point in time, unlike a bank loan which has a fixed monthly repayment.
Many lines of credit are revolving, meaning that with each weekly repayment, the amount you repaid (minus the fees) becomes available again (within the credit limit and the timeframe outlined in their agreement if one is specified).
For established businesses, a line of credit also provides that all important safety net. Opening a line of credit so you have access to emergency funding when you need it is a huge step toward de-risking your business activities. A line of credit allows you to access extra working capital in case of an emergency.
Lines of credit are popular because of their flexibility. You can draw funds whenever you want, use them however you want, and draw the exact amount you want. If you have a rush order and need to purchase materials, you can draw on your line of credit. Lines of credit are popular because of their flexibility: You can draw funds when you want, use them how you want, and draw the amount you want.
How is a line of credit different from a business loan?
A line of credit differs from a traditional loan because you don’t have to use it, but you can use it as a buffer or a fallback option if you have unexpected cash flow issues brought about by late paying clients, unplanned for expenses, or simply by seasonal cycles.
Perhaps the major difference is that a business loan is drawn once, for a specific purpose and is obtained before you need it. A line of credit, on the other hand, can be obtained before you need it and used multiple times for day-to-day activities, however you see fit – paying bills, purchasing inventory, replacing a broken piece of equipment in a hurry, marketing, making payroll, etc.
Another difference is that loan repayments are fixed and paid monthly, and are used when business owners need to borrow large amounts of capital to fund expansion and growth activities.
Are there any fees associated with a line of credit?
Sometimes the flexibility of a line of credit comes with a price. Some lenders will charge you origination fees (a fee for entering into the loan agreement), maintenance fees (fees to keep the line of credit open when you’re not using it), draw fees (a one-time fee you pay on top of the interest rate), and bank wire fees. Fees do vary, so make sure you understand your potential fees before you decide.
Do lines of credit require a personal credit check?
Many banks and fintech companies in the U.S. require a small business owner’s personal credit for underwriting. You may find this problematic because it prevents you from separating your personal and business finances. In addition, using personal credit can hurt your credit score.
It’s a good idea to apply and get approved for a business line of credit before you need it.
How do I apply for a small business line of credit?
The process of applying and getting approved for a credit line varies among financial providers. However, no matter which provider you choose, they will all look at your ability to repay. This means you’ll need to provide some evidence that your business is profitable and cash flow positive.
Because of this, it’s a good idea to apply and get approved for a business line of credit before you need it. Why? We’ll explain:
When you and your business are in a sound financial position, rather than a desperate one, you’re a much more attractive borrower from the point of view of a bank, because it demonstrates your ability to repay the loan. When you start out with a line of credit, many lenders will set a lower credit limit but as you begin to show a reliable repayment history they may increase that amount and offer a more flexible repayment schedule.
What interest rates can I expect?
A business line of credit operates similarly to a credit card, with a revolving balance, but they tend to offer lower interest rates, and there are no fixed payments. Though it’s important to check the lender’s terms and conditions before applying for a business line of credit, most of them are flexible and allow you to pay off the complete balance when it’s convenient for you; you generally won’t have to lose sleep over a prepayment fee.
This benefit does come with a few caveats:
There are lines of credit out there that are just as expensive as credit cards, if not more so. And even if a line of credit doesn’t come with prepayment fees, they might drastically front-load the fees, so you don’t save much by prepaying. If you are hunting for lower fees, it’s always wise to compare carefully and ask a lot of questions before deciding.
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