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A business line of credit is a loan that allows business owners to withdraw money from a set amount instead of borrowing a lump sum. Much like a business credit card, a line of credit is revolving. This means that once you pay off the funds you withdrew, the full loan amount is available again.
If you run your own business, then it’s likely there will be a time where you’re going to need access to readily available cash. You could be looking to increase staff, purchase capital goods, or grow and expand your company. If this is the case, then a business line of credit might be the best option for you.
When you obtain a business line of credit, your lending company will allow you to borrow up to a predetermined amount of capital. It could be $20,000 or it might be $100,000 or more. You’re able to borrow and repay as much as you want within the scope of your total loan amount. Unlike a small business loan, you only pay interest on the money that you actually withdraw. This makes it so you are not paying for money that you might not need right away.
So, how does a line of credit work? To start, you need to know how a lending company will determine if you and your business are a good fit for capital. Your personal credit score will be the first item lending companies will check. Most lending companies prefer applicants with a credit score of 600 or more. From there, they are going to look at how long you have been in business and what your recent revenue has been. Some lending companies will require you to have been operating for more than two years. Others might require as little as 6 months. Revenue requirements really depend on how much capital you are looking to access. It can range from as little as $2,000 per month, or go up to $12,000 or more per month if you are looking for access to $500,000. Finally, a lending company will dig into your accounts receivables and see what kind of physical assets your company has.
Once a lending company determines that you would make a good borrower, they need to determine what the business credit line amount should be. To do this they are going to figure out your current ratio, or liquidity ratio. A current ratio will determine a company’s likelihood to be able pay back short-term and long-term debts. A borrower that is thought to have a strong current ratio is likely to receive higher credit line limits, more competitive interest rates, and attractive repayment schedules.
Companies typically intend to use a business line of credit for two different reasons. The first is when the business is experiencing some unforeseen costs and they need additional cash flow. An example of this might be an auto repair business that needs to replace a broken lift. A credit line would provide the cash to cover this cost.
A second way that a line of credit can help a business is with short-term working capital. Let’s assume that your business is very cyclical during the year and you hit a slow period. You might also have customers with outstanding invoices due. This could cause cash flow to be a little tight as you continue needing to operate and pay your employees. A business line of credit would give you the funds to stay on your feet until you got paid or the business cycles back to a more robust period.
It’s important to remember not to abuse lines of credit. Don’t take out a line of credit so that you can move your business into a larger, more modern office space. A credit line should not be used for large capital expenses like real estate. It’s also not a way for you to cover your normal operating expenses for a prolonged period.
Some might think that a business line of credit and a business credit card are very similar. While both products will give you access to a specific amount of money and allow you to borrow any amount up to that limit, there are some key differences.
Business credit cards are great to use for capital upgrades like new computers. Depending on the credit card, business owners can benefit from rewards on that purchase or even gain some cash back. However, business credit cards frequently come with much higher interest rates than what you will receive with a line of credit.
Another difference is the fees and penalty charges that come with business credit cards. A business line of credit does not typically come with fees. However, business owners may be subject to a maintenance fee if they don’t use the credit line. Fortunately, most lending companies do not impose this fee. Depending on the expense, a business line of credit will usually have a much more flexible repayment schedule than a business credit card.
A huge benefit of lines of credit is that you only pay for what you take. Additionally, interest only applies to the amount you withdraw. For instance, let’s say you have a business line of credit totaling $50,000 and you withdraw $10,000. If you and the lending company agreed on a 10% interest rate, then the interest amount would be $1,000 and the total amount you would be responsible for paying back would be $11,000, not $50,000. Once you have paid off the $11,000, you will have the full $50,000 amount available.
Lending companies set interest rates on lines of credit. Lending companies will often establish the interest rate based on your personal credit score and the current state of your business. Depending on these factors, the rate on the credit line can be lower than a business credit card if the issuer is not offering promotional introductory rates. However, if a lending company believes that a business is a risk, they may set a higher interest rate in order for that business to qualify.
Another factor to consider is that some lending companies will require businesses to pay down their balance to $0 at some point within the year to demonstrate that the business is cash flow positive. Taking this factor into consideration, it would be prudent to only withdraw an amount you believe you will be able to pay down within a short amount of time.
Before you open a business line of credit, make sure you compare lending companies to ensure that you feel comfortable with the terms they are setting for your credit line. Understand the fees they are setting and any additional charges they may be asking you to be responsible to pay. This will help you find the most cost efficient line of credit for your business.
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