When it comes to financing options for small businesses, the business line of credit is the most common- yet also the most misunderstood. In this article, we’ll explain how a line of credit works and also how you can qualify for one. Most importantly, this will help you determine if a business line of credit is best for your business.
How Does a Line of Credit Work?
A line of credit is a type of financing allowing a company to use up to a certain amount of money. To obtain the funds, you request to “draw” from the line. You can pay it back at any time to increase the availability of funds. It operates a lot like a conventional credit card. Many lenders put restrictions on how the line of credit can be used- the primary one being that, since it’s a business line of credit, it can only be used for business purposes. Typically, a line of credit is used to pay suppliers or to cover payroll and other business expenses.
The cost of using a line of credit depends on the size of the credit line and the risk. The borrower pays a financing fee on the outstanding balance. This fee typically varies and depends on the prime rate. Also, some institutions put other fees on their credit lines, such as maintenance and availability fees.
Finally, some institutions require that the balance be paid in full from time to time- usually annually. This is known as “resting the line” and is something to keep in mind if you are considering opening a line of credit for your business.
2 Types of Lines of Credit
There are several ways that a line of credit can be classified- the most common is based on whether there is collateral involved or not:
How to Qualify for a Line of Credit
First of all, you must understand that it’s not easy to qualify for a business line of credit. Lenders usually have a list of criteria that you and your business must meet. Banks lend money based on the three C’s and you and your business need all 3 to qualify. The three C’s are cash flow, collateral, credit score.
Advantages & Disadvantages to a Line of Credit
There are some advantages to opening a business line of credit:
• Quickly improves cash flow
• Flexible, as long as you don’t reach your limit
• Can be used to cover important and unexpected expenses
• Cheaper than most other solutions
That being said, there are also some disadvantages to a business line of credit:
• Difficult to obtain
• Not an option for new businesses with less than 2 years of history
• Covenants are difficult to meet
• Once limit is reached, it’s difficult to quickly increase
• Purchase orders are not collateral, which can limit growth
If you do qualify for a line of credit, the decision is based on your primary business objective. Of course, if you don’t meet the qualification standards, obviously it is not an option. Typically, the decision is based on cost versus flexibility. A line of credit can be inexpensive but doesn’t have the flexibility needed by a growing business. Alternative options may be more expensive- but much more flexible as well.
Do You Need a Business Line of Credit?
If you feel like a business line of credit will meet your needs, contact 18 Sierra Financial to learn more about it. We can help you determine your best financial solution.