A Business Line of Credit – What it is + How to Build One for Your Business
According to the NFIB Research Foundation, 28% of small businesses regularly depend on borrowed money and 47% have a line of credit. A line of credit is where business owners are allowed to withdraw money against a predetermined credit limit when they need it. This type of credit is normally used as short-term working capital to boost cash flow or to pay for unforeseen expenses. A line of credit works in a similar way to a credit card because the line is open for business use and you are only liable to pay interest on the amount of the line that you draw.
Small business line of credit
Small businesses need to be flexible in order to respond to changes in growth or fluctuations in cash flow. A line of credit is useful in these situations as it allows you to gain access to money to deal with your business needs. Interest is accrued as soon as you start to draw funds and the amount you repay (with the exception of interest) becomes available for you to borrow again.
Unsecured line of credit
Generally, a small business line of credit is provided as a form of unsecured debt. This means you do not need to offer assets that would be sold by the lender if you default on the line of credit (collateral). The interest rates on small business lines of credit are variable. Unsecured lines of credit range from $10,000 to $100,000. You may be required to secure your line of credit if you need to borrow more than $100,000. Since collateral is not necessary to obtain a line of credit, you will need to provide evidence that you are generating enough revenue and you have a good business credit rating. Taking a small business line of credit will not put your personal or business assets at risk. Therefore, interest rates on this type of borrowing are normally higher than loans, to offset the risk to the lender.
The differences between a business line of credit and a loan
Term loans are normally fully amortized and you pay interest until the whole amount is repaid. Small businesses typically use term loans for a specific purpose, for example, to buy expensive equipment. Term loans are suitable for businesses that need to use the whole amount to fund a purchase. Additionally, you need to reapply every time you need a term loan, which means you will pay all associated costs, like origination fees, more than once.
A business line of credit is different from a term loan because a line of credit gives you more flexibility. A line of credit is suitable for your business if you do not need to use all of the money at one time. You have the freedom to withdraw money from the line when you need it and you only pay interest on the amount you use.
Line of credit uses
Small businesses typically use their lines of credit for the following:
- Short-term working capital
- Unplanned purchase opportunities
A vendor may be offering a discount on products that you use frequently and it would make financial sense to take advantage of this special offer. Using a line of credit to buy the inventory in bulk, at a discount price would save your business money because the overall cost for your goods will be reduced because you’ve bought the products on discount.
- Offer credit to customers
Market Watch has reported that one in three businesses have invoices in accounts receivable for over 90 days. A small business line of credit allows you to be more confident in offering credit to your customers because it acts as a safety net if your customers fail to pay on time.
- Unexpected expenses
Emergencies and unexpected expenses can be detrimental to small business cash flow. A line of credit can be opened to specifically deal with unplanned expenses, for example, if a stove at your restaurant stops working and needs an emergency repair.
How to build a business line of credit
Building a business line of credit and keeping it in good standing helps improve your business credit rating. This will enable you to secure terms on a more favorable basis should you need business financing in the future. A good credit rating is vital for your small business as 20% of small business loans are denied because of poor business credit.
In addition to diligently managing your business line of credit, the following are some factors that will affect your credit rating:
- Paying your bills on time.
- The amount of credit you have available on credit cards and lines of credit.
- The industry your business operates in.
- The amount of revenue you generate.
- The number of employees you have.
- The number of inquiries that have been conducted on your credit profile.
The following tips will help you build a business line of credit, and subsequently improve your credit rating:
- Research different lenders
You can obtain a small business line of credit from traditional lenders like credit unions or banks that include Bank of America, Wells Fargo, and US Bank. Online lenders such as American Express Bank and Capital One Bank now provide an alternative to securing a line of credit from a conventional lender. You should compare the terms of each lender to secure the best deal for your business.
The U.S. Small Business Administration (SBA) backs some banks to provide revolving lines of credit under the CAPLines program. A revolving line of credit is when a lender offers a business a specific amount of credit that’s always available. When the business repays the amount of money it draws, in either a lump sum or in installments, the credit becomes available again. The CAPLines program could help you to cover your working capital and short-term needs. This type of line of credit is especially suitable for businesses that are new and have been trading for under four years.
The CAPLines program includes the following:
- Contract line – This line of credit is provided for your business to finance material and direct labor costs involved with performing a contract.
- Seasonal line – You can apply for a seasonal line if you need to finance seasonal increases in inventory and accounts receivable. A seasonal line of credit can also be used for labor costs in some circumstances.
- Standard asset-based line – This line of credit would be suitable for your business if you’re not capable of meeting credit standards required for long-term borrowing. You can use the standard asset-based line of credit to fund recurring or short-term needs. The repayment of this line comes from transferring assets into money to pay the lender. Your business is permitted to draw from this line repeatedly, based on your existing assets.
- Small asset-based line – This type of line of credit provides a credit of up to $200,000. It works similar to a standard asset-based line of credit but has less stringent service requirements. Your business has to demonstrate that it has the cash flow to repay the full amount, if necessary.
- Builders line – This line of credit is for small general contractors or construction companies that renovate residential or commercial properties. The builders’ line can be used to fund material and direct labor costs. The building project becomes collateral in this type of credit line.
Prepare your documentation
You will need to provide specific documents to apply for a line of credit. This documentation will include both personal and business financial information.
The following are some of the documents you will need when applying for a line of credit:
- Tax returns.
- Bank account information.
- Profit and loss statement and other business financial statements.
- Personal credit score.
- Employer identification number (EIN).
It’s recommended you start with a low amount for your line of credit. This could be any amount the lender is willing to provide. Starting with a low line of credit allows you to begin improving your business credit score immediately.
Pay on time
Making all repayments on time is a guaranteed way to boost your credit score. Always remember that missing one payment can have negative implications for your business in relation to its future financing needs.
Expand your line of credit
When you have gained a track record by making payments on time, you can increase your line of credit in small increments.
Precautions when building your line of credit
Although more flexible than a conventional loan, a line of credit is still a debt against your business and needs to be handled carefully to avoid jeopardizing your business credit rating. Therefore, you should:
- Be clear on the purpose of the funds – You need to plan what the line of credit will be used for. Carry out an assessment of your business needs to determine where the line of credit would be best utilized. Your line of credit should fit into the long-term strategy for your business as this will provide lenders with confidence when determining your credit limit.
- Take your time when completing the application – You need to give your full attention to completing the application for a line of credit. Set aside enough time to avoid making mistakes. Ideally, you should review the application beforehand to ensure you’ve collected all required information. Before submission, double-check that every part of the form has been completed in full and accurately.
- Be proactive – In general, it’s advisable to apply for a line of credit before you need it. Waiting to make an application when you’re desperate can lead to mistakes. Additionally, lenders may be less willing to give you a line of credit if they know you’re in a tight spot because they may have reservations about your ability to repay. Applying for a line of credit when you have positive cash flow will increase the likelihood of securing the funds.
A line of credit provides financial flexibility for your business and can help you grow your company. You can apply for a business line of credit even if you do not need it because it will come in handy when your business faces an unexpected financial event. Since you only pay interest on the amount you draw, this form of credit can be relatively cheap in comparison to other borrowing options.
Small businesses can use lines of credit to cope with seasonal fluctuations. You can reduce the uncertainty in relation to the labor cost of your seasonal employees by using Deputy. The auto-scheduling feature helps you to accurately schedule your staff to save on costs. As a result, you are able to allocate your line of credit to other areas of your business. To find out first hand what Deputy can do for your business, click on the button below to begin your trial!
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