Give Yourself Some Credit - What is a Business Line of Credit, and When Should You Get One?
August 6, 2021
As a small or medium-sized business owner, you have many financing options to keep your operations going and fund potential expansion. A business line of credit represents a key choice. But how do you know if it's the right selection for your business?
After all, growing your business requires cash. You can try to bootstrap your way to expansion, but that strategy could restrict your pace of growth. This article addresses your alternate financing possibilities so you can optimize your opportunities.
Loans. Credit cards. Lines of credit. Which makes sense for this stage of your expansion? We'll detail how an LOC compares to other similar financing options and when you should turn to this option.
What is a business line of credit?
To understand a business line of credit, first let's think about two other financing options you're maybe more familiar with: a business loan and a credit card.
We'll compare a LOC to a traditional loan in the next section. Here, let's look at the parallels to a credit card, which actually works in a very similar fashion.
As with a credit card, an LOC is a revolving line of credit. You don't receive a large chunk of cash upfront. Rather, you have a pool of capital you can dip into as needed.
Say your business receives a line of credit of $100,000. You need $10,000 for a new set of computers to modernize your workforce. Your access to the LOC means you don't have to apply for a loan or file paperwork for another form of financing. You already have access to the funds.
You spend the cash you need on the computers. Now you just have to pay back that $10,000, at a prearranged set of terms (such as minimum payments, interest rate, etc.). Meanwhile, you still have $90,000 under your LOC to draw on if needed.
How is a business line of credit different from a credit card?
So far, an LOC seems very similar to a credit card. However, there are differences to keep in mind as well.
Unlike many credit cards, you'll have to pay a fee in order to obtain the line of credit. These can come in the form of an annual fee or maintenance costs accrued monthly.
Like a credit card, you only pay interest when you use the funds in the LOC. However, the interest rates you get with an LOC are much better than the often eye-popping financing expenses that come with your typical credit card.
Meanwhile, a line of credit usually involves higher amounts than a typical credit card. While a card will work for smaller business expenses, you can't typically fit larger capital investments under your everyday Visa or Mastercard.
At the same time, the cash available for a line of credit can be used for almost any purchase. You'll have trouble putting payroll on a credit card, for instance. This is easy with a line of credit.
How is a line of credit different from a traditional business term loan?
Under a traditional business loan, you receive a lump sum all at once. Then, you repay that amount, plus interest, on a pre-set schedule.
A line of credit works differently. You have access to the money if you need it. However, you don't actually receive a lump sum.
What are the advantages of a business line of credit?
A line of credit offers many advantages for your small or medium-sized business. Here are a few benefits you can receive:
- Add Flexibility: With an LOC, you get the financing you need when you need. A line of credit gives you the ability to make decisions on the fly and respond better to circumstances.
- Keep Financing Costs Low: You'll get a much better rate for your LOC than you will for a credit card. At the same time, the overall costs will likely be less than a loan.
- Stay Prepared: Managing your business involves constant surprises. A line of credit gives you the backstop you need to handle anything that comes your way.
So what can a line of credit do for your business? Here are some ways to use your business LOC:
Smooth Out Seasonal Fluctuations in Your Business
Do you get a rush at certain times of the year (Christmas, summer, etc.) and then extended lulls during other stretches of time? A line of credit can help smooth those out. Borrow against it in the lean times and pay it back as cash rolls in.
Avoid Cash Flow Problems
You're hit with a COVID resurgence and have to manage restrictions. A big client is late in paying its bill and your payroll is in jeopardy. A major piece of equipment suffers a sudden meltdown, unexpectedly shutting down production.
A line of credit can help you overcome these challenges. You'll have the resources needed to handle any hiccup in your cash flow or any sudden emergency.
Take Advantage of Sudden Opportunities
Not every business surprise is bad. You can also face unexpected opportunities. A rival business is suddenly ready to sell. A major new client wants a big order quickly. The line of credit also lets you capture these future-changing moments.
With an LOC, you get the financing you need when you need. A line of credit gives you the ability to make decisions on the fly and respond better to circumstances.
How to apply for a business line of credit
Most financial institutions offer lines of credit. Like loans, you'll need to apply and get approved for the financing. This requires that you present a relatively detailed financial picture of your business. Be prepared to produce:
- Balance Sheet
- Profit/Loss Statements
- Tax Returns
As a small business owner, you might also have to submit personal financial information as well. If your company doesn't have sufficient credit to receive the LOC on its own, you may be asked to personally guarantee the financing. That means if something goes wrong, you would be responsible for repaying any outstanding cash taken out through the line of credit.
Tips to maximize your business line of credit
As you consider a line of credit, here are four tips to get the most out of the product:
1. Compute the Right Amount
If your LOC is too small, you won't have sufficient funds when you need them. If it is too big, you might end up paying for access to cash you never need. Figure out the perfect amount for your business before applying.
2. Get It Before You Need It
Since you need to submit your finances to get an LOC approved, you'll get a better deal when your business is booming. This is when you should secure your line of credit. If you wait until you need the cash, you might not qualify.
3. Shop Around
Different financial institutions offer different LOC plans. You might find it convenient to start with your current bank. However, don't jump on the first product you see.
Small variances in the terms of an LOC program can matter a great deal when it comes to tapping into the credit line. Don't be afraid to compare multiple sources. It might add to the hassle of the process, but ultimately you'll get a better deal.
4. Create an Overall Financing Plan
Consider your overall financing situation. Make the LOC part of a comprehensive plan that maximizes your access to cash and best supports your growth. At the same time, take steps to control your indebtedness and manage your risks.
Getting the Most out of Your LOC
Securing a line of credit offers many benefits to your small business. You'll get a low-cost financial safety net and added flexibility to fund expansion. However, you need to look at the details of individual programs and find the right one for you.
[A LOC gies you] a low-cost financial safety net and added flexibility to fund expansion.
Take a look at your current business. Determine if an LOC makes sense for you. You can use the information here as a starting point to apply for the perfect financing option for you.