How Does a Business Line of Credit Work?

Commercial lines of credit are one of the most popular and most misunderstood financing products for small businesses. This article helps you understand how a line of credit works and gives you an idea of the qualification requirements. More importantly, it helps you decide if a business line of credit is the right solution for your business.

A business line of credit provides flexibility that a regular business loan doesn’t. With a business line of credit, you can borrow up to a certain limit — say, $100,000 — and pay interest only on the portion of money that you borrow. You then draw and repay funds as you wish, as long as you don’t exceed your credit limit. A line of credit is similar to how credit cards work.

Need to manage cash flow? Buy inventory? Pay for a surprise expense? Then a business line of credit makes sense.

A small business line of credit (LOC) allows you to draw against a predetermined credit limit, as you need it, instead of receiving the full loan amount at one time like a term loan. The biggest advantage of a business credit line is that you only pay interest on the funds you actually draw.

What is a business line of credit?

A business line of credit can be used to finance your business and operations. You borrow up to a limit specified by your financial institution and interest is applied once you withdraw funds. When the withdrawn amount is repaid, you’ll gain access to the full amount of your credit limit -- similar to a credit card.

A business line of credit can be a valuable tool for small businesses that take a strategic approach to making sure they have access to the resources they require to meet day-to-day working capital needs and fill other short-term financial necessities. It allows them to apply and qualify today for borrowed capital they may need down the road. Many businesses use a line of credit as part of a larger capital access approach including short-term and longer-term financing to fuel growth and fund other revenue-generating projects.

A business line of credit (LOC) is a revolving loan that allows access to a fixed amount of capital, which can be used when needed to meet short-term business, needs. A LOC is one of the tools a business can use to finance short-term working capital requirements, such as:

  • Purchasing inventory
  • Repairing business-critical equipment
  • Financing a marketing campaign
  • Bridging a seasonal cash flow gap

 

How Does a Business Line of Credit Work?

A business line of credit differs from a term loan, which provides a one-time lump sum of cash upfront, repaid over a fixed timeframe.

With a line of credit, you can keep reusing and repaying it as often as you’d like, as long as you make payments on time and you don’t exceed your credit limit. Most lenders allow you to repay your balance in full early to save on interest costs.

Line of credit borrowing limits — typically ranging from $5,000 to $150,000 — are smaller than a term loan.

Business lines of credit with lower credit limits are typically unsecured, which means collateral such as real estate or inventory is not required.

Let’s say you’re the owner of a candle-making company and you have a business line of credit with a $10,000 limit. There’s an upcoming event and you need to make 5,000 candles, so you draw $2,500 from your business line of credit to pay for materials and production costs. You’ll still have access to the remaining $7,500. Once you’ve repaid the $2,500 plus interest you borrowed, you’ll have access to the full $10,000 again.

There are many benefits to a business line of credit:

  • It gives you the flexibility to access funds as you need them and can be a great option when paying for everyday company expenses.
  • You don’t need an extensive credit history or an outstanding credit score to secure a business line of credit.
  • A business line of credit gives you the opportunity to build your credit score.

While there are benefits to a business line of credit, it also comes with its challenges. It’s subject to credit review and annual review, which means your interest rate and credit limit can change based on review findings.

Business lines of credit are also accessible to those who have poor credit scores. However, lenders might offer these riskier clients higher interest rates based on their credit history.

How to Apply for a Business Line of Credit

Business line of credit qualifications

If a business line of credit sounds great for your company -- there are a few qualifications you need to meet in order to apply. Below are some of the common items you might need when applying for a business line of credit:

  • Personal credit score
  • Bank account information
  • Personal and business tax returns
  • Business financial statements
  • Information identifying your business -- for example, an Employer Identification Number (EIN)

Mistakes to avoid when applying for a business line of credit:

  • Not having a clear vision of what the funds will be used for - Before applying to a business line of credit, sit down and determine what you’ll use the money for. Having a long-term vision for your business contributes to providers looking on your company more favorably when deciding your credit limit.
  • Applying for a line of credit when you’re desperate - Rule of thumb is to apply for a line of credit before you need it. If you apply when your business is growing and you have positive cash flow, you’re more likely to receive financing when the lending firm reviews your financial statements.
  • Rushing through the application - It’s important the application is filled out properly. Simple mistakes, such as entering an incorrect identification number, can cause problems. Take your time on the application and be sure to leave contact information -- either a phone number or email address -- so the bank or lending company can reach you with questions.

How to Use a Business Line of Credit

A line of credit is a financing solution that allows a company to draw up to a predetermined amount of money. To get funds, you simply request a draw from the line. You can pay the line back at any time, which increases your funds availability. Most simple revolving lines of credit operate much like a conventional credit card operates.

Lending institutions restrict how you can use the line of credit. Obviously, since it is a commercial line, it can be used only for business purposes. Companies use these facilities to cover short-term needs such as paying suppliers, covering payroll, and handling other corporate expenses.

The cost of using a line varies based on the size of the line and the risk. The financing fee is paid on the outstanding balance. It is usually variable and tied to the prime rate. Additionally, lines may have other fees such as maintenance fees and availability fees. These fees vary by institution.

Lastly, many banks require that your company repay the full balance of the line every so often (e.g., every year). This practice, often referred to as “resting the line,” is something to keep in mind if you are considering this type of a product.

What You Need to Know Before Opening a Business Line of Credit

Before opening a LOC, make sure you understand your chosen lender’s qualification criteria, loan conditions, interest rates, and fees.

  • There may be charges for account set-up, transactions, and annual fees. For example, a bank may charge an opening fee of $150 (or more depending upon the credit account) with no annual fee for the first 12 months, but an annual fee at the beginning of the second year.
  • In order to reduce risk, it’s not uncommon for the lender to require the business pay down their outstanding LOC balance to $0 at some point during the year, often for at least 30 days. This assures a lender that the borrower is generating sufficient cash flow to operate independent of the LOC, and not relying on the financing as a substitute for cash flow or owner’s capital.
  • Due to the unpredictable nature of the market, a lender might reserve the right to call any LOC payable immediately. This means the full balance would have to be paid and the LOC reduced to zero without warning. If your business depends on the line of credit, this can be a critical impediment, so the business should always be prepared to either replace the LOC or scale back in order to weather the loss of credit.

How is a business line of credit different from a term loan?

A business line of credit is different from traditional term loans because it gives you a pool of funds to withdraw from as necessary. A traditional term loan provides a lump sum of money that needs to be repaid within a fixed timeframe.

There are two types of business credit lines you can apply for: secured and unsecured.

How to qualify for a business line of credit

Most traditional lenders, such as banks, require businesses to have strong revenue and at least a few years of history to qualify for a line of credit. Larger lines of credit may require collateral, which can be seized by the lender if you fail to make payments.

To apply, lenders typically require the following documentation: personal and business tax returns, bank account information and business financial statements, such as profit-and-loss statements and a balance sheet.

Online business lenders typically have looser qualifications than banks. However, these lenders are also likely to charge higher rates than banks and may have lower credit limits.

At a minimum, you’ll need at least six months in business and $25,000 in annual revenue to qualify for a business line of credit. Although some lenders don’t set a minimum credit score, borrowers most likely will need a score of 500 or higher to qualify.

Types of business line of credit

There are a number of ways to classify lines of credit. The most common way to classify them is based on whether the banks hold collateral directly or not.

a) Secured lines

A secured line of credit can use personal and corporate collateral to secure the repayment of a loan should the business owner default on payments. This security allows lenders to foreclose on assets if necessary.

Banks can use different asset types as collateral, including accounts receivable, machinery, inventory, cash, certificates of deposit, securities, and real estate. The bank or lending institution usually secures its position by filing a UCC lien (or similar instrument) against the pledged assets.

b) Unsecured lines

An unsecured line, on the other hand, does not have specific collateral that is pledged as security for the line of credit. While this approach gives your assets some protection, the protection is far from perfect. This last point is very important and is often missed by business owners.

Most unsecured lines are usually guaranteed by the company and by the owner personally. You could argue that the loan is secured by your guarantees. These guarantees often allow the bank to sue your company and the business owner personally in case of default. Obviously, if the lender wins the lawsuit, it could foreclose on your corporate and/or personal assets. In reality, no line of credit or business is ever completely unsecured.

Business credit cards

Business credit cards are also lines of credit, but differ from a traditional business line of credit in several ways.

A business line of credit provides a higher credit limit, may be secured by collateral and provides actual cash to your bank account when you make a draw. You can get cash through a business credit card, but you’ll be charged fees and a higher APR to do so. Other common fees for business credit cards include annual fees and late-payment fees.

Business credit cards work best for smaller ongoing expenses and for newer businesses without established finances, while a business line of credit works best for larger ongoing expenses and more mature businesses.

Just like personal credit cards, business credit cards can provide rewards or cash back for spending. Rewards are typically related to business expenses, such as office supplies, gas, internet and cable. They may also offer 0% interest promotions, which allow you to pay no interest on your balance for a specific time period after signing up for the card.

How to Determine the Business Line of Credit Amount

Credit lines typically have smaller borrowing limits than term loans, which make them ideal for unexpected charges but not for large capital investments. If you’re looking for more than $100K in funding then you’ll want to consider a traditional bank. Anything less than $100K makes you a good fit for an online lender.

Benefits and drawbacks of a business line of credit

Lines of credit have some distinct advantages, including:

  1. They can improve your cash flow quickly
  2. They can be flexible as long as you don’t reach the limit
  3. They can be used to pay for important and emergency expenses
  4. They are cheaper than most alternative solutions

However, like any business solution, lines of credit are not perfect and also have a number of disadvantages:

  1. They are hard to get
  2. They are not an option for startups or companies with less than two years of trading history
  3. Covenants can be hard to meet
  4. Once you reach the limit, it’s hard to increase it quickly
  5. Purchase orders are not considered collateral – this restriction can limit growth

Assuming your company qualifies for a line of credit, the decision to use one comes down to your main business objective. If you cannot meet the qualification requirements, obviously a line is not an option.

Often, the decision is a matter of cost vs. flexibility. Lines of credit can be inexpensive, but they often lack the flexibility that growing small businesses need. Other options tend to be more expensive but are also more flexible.

Can You Get a Business Line of Credit with Bad Credit?

What is a credit score?

A credit score is the assumed risk a lender adopts when you borrow money from them. This number is calculated by looking at your loan and credit card payment history, length of credit history, types of credit, and total amount owed.

Credit scores range from 300 to 850. And, while the guidelines for a good or bad credit score vary by lender, some ranges are used to evaluate whether or not your credit score is in a good place.

  • Great credit score: 740 to 800
  • Good credit score: 670 to 739
  • Fair credit score: 580 and 669
  • Bad credit score: 579 or lower

Will a bad credit score prevent me from securing a line of business credit?

No, but it might be more difficult to obtain a line of credit with an affordable credit limit and interest rate. Luckily, there are ways to improve your credit and providers that work with a variety of different business types and credit situations.

Business Lines of Credit with Banks

Even those small businesses that meet high qualifications for a top-tier business line of credit at a bank might find it difficult to get funded unless they bring other business or accounts with them. Credit lines are less predictably profitable (compared to a term loan, for example), which means banks can be reluctant to offer them as a stand-alone product.

Lenders that participate in the SBA 7(a) loan program may also offer SBA CAPLines credit, which have limits of $5 million but have high qualification requirements. For more information, read our in-depth article on CAPLines.

Qualifying for a top tier business line of credit at a bank or through the SBA’s CAPLines program will typically mean demonstrating to a lender that you have:

  • Credit score of 680+ (check your score here for free)
  • 2+ years in business
  • $10k+ in average monthly revenues (trending positive)
  • Ability to pledge short-term or hard assets
  • Profitable
  • No recent bankruptcies, foreclosures, or tax liens

Credit Limits

Traditional banks often have business credit lines with limits from $10k – $100k. Some lenders will have higher limits, but those are often reserved for only the best borrowers and need to be backed by significant collateral.

Interest Rates

Traditional lenders typically offer the most competitive interest rates, somewhere around 5 – 13%. They’ll also offer longer repayment terms than online lenders. This is a double edged sword. While the monthly costs are likely to be less, the total cost of capital could end up being higher with a traditional bank if you’re in repayment for a significant amount of time (3-5+ years).

Collateral

The reason banks are willing to provide larger lines of credit at lower interest rates is because bank LOCs are typically secured by collateral. A line of credit can be secured by real estate, equipment, or other business assets. Some banks will let you use your business savings or checking account as collateral as long as you maintain a certain amount of funds in that account.

Banks typically will not want to take a 2nd position on any of your collateral. Generally the bank will want you to refinance any outstanding loans you currently have through a new term loan with them.

For example, if you currently have a $5,000 equipment loan then a bank will not want to move forward with a LOC until you have refinanced the equipment loan through a new term loan with them. This allows the bank to have a 1st position UCC lien on 100% of your assets, which is very important to most traditional lenders.

Repayment Terms

Banks offer the best repayment terms, if you qualify. Many banks will offer 1-5 years to pay off your amount, and many will start the clock over when draw against your line again.

Application Process

The application process with a traditional lender can be lengthy. Most still have pretty old-school underwriting procedures and a relatively risk-averse culture. Getting approved for a small business LOC with a traditional lender can easily take weeks, and many trips to the bank.

Establishing a business line of credit with a bank can be limiting in some ways. It can have an impact on your ability to work with multiple financing partners both now and in the future. If you just want a quick line of credit to meet your needs then you may not be up for the process, requirements, and restrictions that a business line of credit from a bank comes with, even if it is more affordable.

Business Lines of Credit With Online Lenders

With small business lines of credit from traditional banks difficult to come by, it’s fortunate that so many online lenders like OnDeck have stepped in to meet the demand. These alternative lines of credit are typically more expensive but they might be a good fit for a borrower that can’t meet the bank’s qualifications, or one that just wants more flexibility.

To qualify for a commercial line of credit from an alternative online lender, you’ll typically need to show that you have:

  • Credit score 600+ (check yours for free here)
  • 6+ months in business
  • $2.5k in average monthly revenues
  • Ability to pledge short-term assets (like accounts receivable)
  • No recent bankruptcies, foreclosures, or tax liens

Credit Limits

Most alternative lenders will start qualified borrowers out on conservative credit lines, meaning they might set a lower limit or have a higher-frequency repayment schedule. As the lender becomes more familiar and comfortable with your payment history, you will likely be able to get a higher limit and a more friendly repayment schedule.

Interest Rates

APRs for most credit line products from alternative lenders are around 20% – 40%.

These costs are similar to what you pay with a small business credit card, but with a business line of credit you get access to cash you can put in the bank. This is an advantage because you can use it to make unexpected payments that require cash.

Collateral

Alternative lenders typically don’t require specific collateral for a line of credit, but they usually do place a blanket lien on business assets. This can make it hard to get additional loans or credit lines while you’re paying off existing ones, unless you’re willing to refinance and consolidate the debt. Traditional lenders may also place a lien on your assets, in addition to any pledged collateral.

Repayment Terms

Online lenders are going to offer repayment terms that are less than a bank, in most cases. Many online lenders only allow 6 months for you to repay the balance of your credit line. However, this time restarts every time you draw on the line.

Application Process

Online lenders have leveraged new technologies to provide small business LOCs faster and with less paperwork. While some have the ability to provide credit limits as high as $500K, most of the credit lines range from $5K -$100K. Qualified applicants are usually funded in just a few days.

If you’re a stronger borrower, do not need the funds immediately, and can be approved through a bank then that is likely the best option for you. However, if you don’t meet the bank’s qualifications, or if you need funding very quickly, then you should consider OnDeck as a good alternative solution.

Applying for a Business Line of Credit: Banks vs Online Lenders

While a business line of credit from a bank can be the most affordable option, it is not the easiest application process. When you apply for a business line of credit through a bank you will have to provide a lot of documentation (full tax returns on you and your business, business P&L statement, projected financials, any current leases, etc.) that online lenders don’t require.

Banks typically have many layers of approvals that your line of credit will go through before you can gain access to funds. It is also likely that you will be pitched many different products while going through their approval process. Both of these attributes can be very frustrating to you when you are trying to get a business line of credit quickly.

Applying for a business line of credit with an online lender, like OnDeck, can be done within minutes and you can have money in your bank account within a few days. You can do the entire process online, at your convenience.

References:

[1] Business Line of Credit: How It Works and Best Options https://www.nerdwallet.com/blog/small-business/business-line-of-credit/

[2] How Does a Commercial Line of Credit Work? https://www.comcapfactoring.com/blog/how-does-a-business-line-of-credit-work/

[3] The Plain-English Guide to a Business Line of Credit https://blog.hubspot.com/sales/business-line-of-credit

[4] What You Need to Know About a Business Line of Credit https://www.ondeck.com/resources/need-know-business-line-credit

[5] Business Line of Credit: What It Is, Where to Get One, & More https://fitsmallbusiness.com/what-is-a-business-line-of-credit/

[6] Which Unsecured Business Lines of Credit are Best for Your Business? https://www.sba.gov/blogs/which-unsecured-business-lines-credit-are-best-your-business