Various financing products can help small businesses with specific needs, but few of them are as versatile as a business line of credit. Some of the terms of a line of credit can be confusing, however, so knowing how they work will be key to maximizing its use to benefit your small business and evaluating whether a one is the best option for your business.
It’s also just as important to know the exact terms of a line of credit so you can compare lenders and know beforehand if you’re comfortable with the fees and repayment requirements that come along with a business line of credit, as those terms differ considerably from other types of financing, such as bank loans and even business credit cards.
What is a Business Line of Credit?
A business line of credit gives you access to a credit line that you can use whenever you need it and to spend on whatever business expense you see fit. You only pay interest on the amount you’ve borrowed for your business. Often, a line of credit is used to cover short-term business expenses in between payment periods; but it can also be used for any other business expenses, such as handling growth opportunities, and some financing companies even allow business lines of credit to be used in making small real estate purchases, depending on the credit limit.
Business lines of credit are issued directly by traditional banks, credit unions, and some specialized online lenders, while alternative lenders and small business brokers typically offer lines of credit through a marketplace – a group of lenders that the alternative lenders and brokers have partnered with that will make competing offers for your business.
Also, lines of credit tend to charge a variable rate on the amount you borrow, while a term loan typically charges a fixed rate. Similar to loans, however, lenders and financing companies will base the interest rate on your FICO and business credit scores, as well as other factors.
Business lines of credit are very different from other forms of financing:
- Business lines of credit differ from term loans because with a term loan, you are receiving a lump sum of cash for a specific purpose that often must be approved by the lender, and you must start making payments on a loan with interest almost immediately.
- Also, while a business line of credit is conceptually similar to a business credit card in that it provides a line of credit that can be drawn upon, it has very different repayment terms and fees than a credit card. While you can draw a limited amount of cash from a business credit card, that cash usually must be paid back at an extremely high interest rate.
- Lenders charge a variable interest rate on the amount you draw upon from a business line of credit, which is typically the prime rate plus several percentage points. The interest rate is typically higher than a term loan, but remember, with a term loan you must pay interest on the entire amount of the loan, whereas with a line of credit you only pay interest on the amount borrowed.
What are the Typical Fees of a Business Line of Credit?
For an unsecured business line of credit (one that does not have to be backed by collateral or a personal guarantee), there are fees and repayment terms that differ from most other forms of financing. Some of the fees may be waived if you take out a secured line of credit.
These main fees include:
Origination fee.
The origination fee can be up to 2% of the total line of credit, but may be waived by some financing companies if you have a past relationship with the lender or your credit is exceptional.
Maintenance/non-usage fee.
The maintenance fee is typically charged monthly or annually in order to keep your line of credit open, and can be up to 2% of the total line of credit. It is often charged if you have a business line of credit but don’t draw upon it for long periods of time.
Draw fee.
Some financing companies and lenders may charge you a fee every time you draw upon your line of credit. This fee will depend upon the relationship you have with your lender, as many traditional banks and alternative lenders are willing to waive this fee.
Annual fee.
Many lenders will waive this fee, especially if you are a long-time customer. It is usually a small, flat fee, often of up to $200, depending on the lender.
What are the Conditions of a Business Line of Credit?
Lines of credit have very different repayment and withdrawal terms than term loans and business credit cards and should be a major factor when considering whether you want to take one on. Before you agree to take on a line of credit, you need to carefully consider the terms and shop around for a deal that best suits your small business.
Some of the most common conditions you can expect are:
Somewhat stringent requirements.
Getting approved for a business line of credit is tougher than getting approved for a business credit card, but slightly easier than a business loan. When you apply for a line of credit, most financing companies require good-to-excellent FICO and business credit scores, a minimum annual revenue and a minimum time in business, often at least two years. You must also have a strong cash flow, and if you have borderline credit scores, some may require a personal guarantee and collateral, which includes any high-value assets you may own.
Minimum withdrawal amounts.
Most financing companies require a minimum withdrawal amount when you tap into your line of credit, often $5,000. Additionally, with some providers, it may take up to 24 hours to obtain those funds once you’ve requested them. Unlike a business credit card which can be used for small purchases of specific items, lines of credit should be used for larger business expenses such as payroll or additional inventory.
Pre-scheduled repayments.
Repayment terms of a business line of credit are more stringent than those of a loan or a business credit card. Depending on the terms you agree to with the financing company or lender, you may be required to make weekly or monthly payments once you’ve borrowed against your line of credit. You also may be required to pay off your balance in full on an annual or sometimes monthly basis, depending on your credit agreement.
Renewal schedule.
Most providers require you to renew your line of credit at various intervals, often on an annual basis.
How Can Businesses Use a Line of Credit?
The benefits of a business line of credit are many, mainly because you can use oen for any business expense you wish. That doesn’t mean, however, that you shouldn’t be judicious in how you spend the money that you borrow against your line of credit. Generally, lines of credit can be used for:
Seasonal operating expenses.
A business line of credit can smooth out your cash flow by covering expenses such as payroll, inventory and rent during your small business’ offseason, or to cover short-term expenses when you’re waiting for a batch of invoices to be paid or if there’s a sudden slowdown in the economy.
Marketing tools.
Your business may offer the best products and services in the world, but it won’t do you any good if nobody knows about them. Getting the word out about your business usually requires a strong, multi-front marketing effort. This may include online and social media advertising, a well-optimized website and email campaigns. These services take time and effort and aren’t cheap, especially if you decide to outsource them. This is where a business line of credit can be very handy.
Handling big contracts.
Landing a big contract, especially a government contract, is always exciting for your small business. A business line of credit can help you conveniently purchase the inventory and resources you will need to handle that contract and strengthen your business’ reputation.
New product development.
Your business likely can’t grow without offering new products or services, but developing and marketing those new products can be costly. A business line of credit can help you meet the expenses required to bring a new product or service to market and grow your business.
Get the Business Line of Credit That’s Right for you
There are many lenders and financing companies that offer business lines of credit in both the traditional and online space, but they all have different requirements and different terms. If you are considering taking out a line of credit, make sure you check with several different providers and compare. Each provider will offer different credit line amounts, different rates and varying repayment terms and fees. Make sure you obtain the line of credit with the requirements that are right for you and your business.