A business line of credit: What it is and how it works

Highlights:

• A business line of credit is a financing option that some growing businesses consider when they need access to credit.
• A business can draw funds from the line of credit up to the credit limit and it pays interest on the amount borrowed.
• Some benefits of having a line of credit include the ability to manage cash flow and the chance to establish a business credit score.

Small businesses require funding to operate and expand, and a business line of credit can be a good financing option. Whether it's for hardware and equipment, raw materials or a lease on a larger office, a business line of credit may offer quick access to the funds needed for these kinds of investments.

In this article, we'll dive into what kind of credit this is and how it works, as well as additional details to help you determine if a line of credit could be the right financing option for your business.

What is a business line of credit?

A business line of credit is a revolving credit account that provides businesses with access to funds up to a limit that is determined during the approval process. Interest starts accumulating once you withdraw funds, and you pay it down while still using your line of credit. You do not pay interest on the portion that remains unused.

Business lines of credit are typically used for many of the same things credit cards are used for, including raw materials, advertising, office equipment and software. However, there is one potential key difference. You may find that a business line of credit is a good option for funding larger purchases that might exceed a credit card limit.

How does a business line of credit work?

You, the borrower, have a credit limit and can draw on the funds as needed, up to that limit. Interest is only charged on the amount borrowed, and you can choose to make minimum payments or pay off the balance in full. The credit line remains open, even after the borrowed amount is repaid, allowing you to keep drawing on the funds as needed.

What is the difference between secured vs. unsecured lines of credit?

There are generally two categories of loans — secured and unsecured.

• Secured lines of credit require collateral, this means you put up some kind of asset to serve as payment if you default. Examples of secured lines of credit include mortgages, auto loans and home equity lines of credit (HELOC). These loans usually have lower interest rates, but stricter approval requirements.
• Unsecured lines of credit do not require collateral. Without an asset to back it up, unsecured loans are considered riskier to the lender. Because of this, they typically come with higher interest rates. Approval for these loans relies heavily on your credit score, which gives lenders an indication of your likelihood to pay back the debt. Examples of unsecured lines of credit include student loans, credit cards and yes — many business lines of credit.

What is the difference between business lines of credit and business credit cards?

There are several scenarios in which you may want to consider one type of financing over the other.

Why choose a business line of credit?

Business lines of credit are often used to finance larger business expenses that you may want to pay off over time, since they often come with larger credit limits. Therefore, it may make sense to have as your business grows or you need to invest in expensive equipment or raw materials.

For example, if you need to purchase special machinery for your manufacturing business and it costs $100,000, a business line of credit may make the most sense given that dollar amount is higher than most credit cards limits.

Why choose a business credit card?

Business credit cards are often used to make less expensive and short-term purchases. You may be able to find one with a low promotional introductory rate and aim to pay off the balance during that period of time.

If you need to purchase a laptop for a new employee for $1,200, for example, you may want to consider using a business credit card and pay that off when your balance is due (or within a low APR introductory period of time).

Another differentiating factor is the ability to earn rewards on your business expenses. If you do a lot of business travel or dining out on expense accounts, you may get more bang for your buck with a business rewards credit card than you would with a line of credit. With a rewards credit card, you can earn points for every eligible dollar you spend and redeem them for cash back or travel perks.

What are some other advantages of a business line of credit?

In addition to financing the growth of your company, a business line of credit has other benefits.

• Manage cash flow. A line of credit may provide a safety net for those unexpected expenses, overage mistakes or seasonal periods of slow sales.
• Remain flexible because of liquidity. When you have access to cash through a line of credit, you can pay your bills on time while maintaining flexibility as new opportunities or vendor relationships arise.
• Establish a business credit score. This business credit score, similar to your personal credit score, is a way for lenders to evaluate your creditworthiness. The higher the score, the better interest rates and lines of credit you might be considered for if you ever want to apply for a business loan or other kinds of financing. When it comes to business relationships, this score may even act as a signal to potential vendors, suppliers and other strategic business partners on how your business manages its credit.

Where and how to get a business line of credit

If you're ready to consider a business line of credit, you can apply for one at a bank, credit union or a number of online lenders. Different lenders may have different requirements and application processes. It may be a good idea to compare rates and terms from several financial institutions before deciding what option is best for you. Given your specific needs, you’ll also want to decide if a secured or unsecured line of credit makes the most sense.

The application process generally requires financial documents and other credit-related information. This includes:

• Bank statements
• Tax returns (both personal and business)
• Business credit score
• Your EIN
• Years in business
• Annual revenue
• Other debt obligations
• Industry that your business falls under

All of these are important factors in deciding whether or not to approve your application for a business line of credit; they may also affect the terms of your loan.

The full approval process may take several weeks and be more rigorous than qualifying for a credit card. This is because business lines of credit typically have higher credit limits and lower interest rates and therefore require a higher level of creditworthiness.

In summary

A business line of credit can be an effective way for small businesses to manage their cash flow and be strategic about funding revenue-generating initiatives. By understanding the benefits of a business line of credit and how they differ from other financing options, business owners can make informed decisions about how to approach their fiscal maintenance and growth.