If you are a small business owner trying to grow, getting financing can be tricky. Whether you want to prepare for financial emergencies or smooth out your company’s cash flow, it is important to know what type of financing works best for you, and when. Is a business line of credit or a loan better for your company? Here is everything you need to know about your options. But be careful—there are risks.
Understanding the business line of credit
Similar to the way a credit card works, a business line of credit provides your business access to a pool of money up to a certain limit. With a business line of credit, you can withdraw money when you need to and pay interest on only that amount. In other words, you do not have to pay interest on the total amount you have available. Some lines of credit have an expiration date after a set period. Other lines of credit, meanwhile, are revolving, meaning you can reuse the money after you have repaid it—and without being forced to reapply.
Essentially, a business line of credit gives small businesses in particular enough flexibility to finance on their own schedules. Instead of receiving a single lump sum, like you would when you receive a business loan, you are able to access a line of credit up to a certain dollar limit.
Typically, a business line of credit ranges from $1,000 to $500,000, with as low as 8% APR or up to 24% APY. If you have bad credit and open a business line of credit, you will likely pay a higher rate. While it is uncommon to get a business line of credit without undergoing a credit check, you might qualify with a personal credit score rather than a credit score for your business.
When should you use a business line of credit?
A business line of credit is normally used for anyone who has a seasonal business, for instance. In that case, a line of credit can help your business pay any payroll or overheads in the off season. A line of credit may also be useful to you and your business if you are awaiting payment from clients and you need to cover the costs in the meantime. You may also use a line of credit to receive bulk purchase prices on inventory. Compared to a term loan, repayments on a business line of credit are more flexible and you can usually pay in lump sums without being forced to pay penalties.
If you feel your business may require a line of credit, it is best to get one before you absolutely need it. The reason is that if you apply for one when your business is doing well and you have a healthy cashflow, you are more likely to get approved—and with better terms. Lenders require bank statements, balance sheet, and income statements with the application.
You will also be asked to provide a credit history for your business. In some cases, you will need to provide your personal credit history as well. Unless your company has been earning money for a few years, some lenders will not approve a line of credit.
The risks of over-using a business line of credit
One risk of over-using a business line of credit can arise if you attempt to use it to manage your payroll over the long term or to cover for losses. Your business could also suffer from cashflow issues if you constantly use a line of credit for routine spending. In that situation, you would likely have to overhaul your accounts receivable process. It would probably be a better idea to use a term loan with lower interest rates if finance is a medium- or long-term part of your solution.
Business line of credit vs. business loan
Both a business line of credit and a business loan have their merits. Both will help you build your business credit score and lender reports payments to the credit bureaus. On the one hand, a business line of credit will allow you to borrow as much as you need during a set period because of a flexible credit line. Additionally, you can receive access to capital because a line of credit is replenishable.
A business loan, on the other hand, will give you a lump sum of money. In this case, if you want to qualify for more money, you have to apply for an additional loan. One benefit of a business loan is that it comes with a fixed monthly payment, making it easy to budget and repay the balance.