Business line of credit: What every entrepreneur should know.
While business lines of credit are common, they can also be confusing, so it's important for potential borrowers to understand how they work before using one. Here's what you need to know.
What's a business line of credit?A business line of credit is similar to a personal one: You're able to borrow a certain amount of money when you need it. If you're in a delivery business and a car breaks down for example, you can tap into your line of credit to pay for that repair. Owners of seasonal businesses may need to use a line of credit to pay for merchandise in July to sell in December.
Typically, lenders only charge interest on what you use, so if you borrow $10,000, you'll only have to pay interest on that amount even if your line of credit is $50,000. Lines of credit are also revolving lines of credit, which means you can tap into one over and over again as long as you pay back what you owe.
But there's one big difference between business and personal lines of credit. Business lines of credit usually come with a much higher borrowing amount, since businesses typically need more money than households to operate, and it can range from $5,000 to $150,000.
How to apply for a business line of credit.
When you apply for a business line of credit, banks and other traditional lenders usually want to view your revenue history, tax returns, bank account information, a balance sheet, and a profit-and-loss statement. And generally speaking, your business will need to be up and running for six months and will require at least $25,000 in annual revenue. You typically also need a credit score of 500 or more, as lenders want to know you'll pay them back.
Watch out for fees.Many people think that lines of credit come with an interest rate and that's it. Unfortunately, there are often additional fees that can increase the total loan cost. For example, some banks charge origination fees, which are costs to set up a loan. Depending on the type of loan, there can also be administration fees, pre-payment fees, annual fees, and more.
Then there's the interest rate, which some banks determine based on your credit score. If you have an excellent credit score, lenders are more likely to consider you a trustworthy borrower and will feel more comfortable loaning you money at a lower rate. If you have a lower score, prepare to pay more – rates can range from a few percent to about 20% or more, depending on the lender.
Rates are also determined by the Federal Reserve's Fed Funds rate. When it rises, as it has over the last three years, borrowing costs climb too.
Secured versus unsecured.
While lines of credit or working capital-related loans are essential to helping business owners manage their day-to-day cash flow needs, there are other types of loans too.
A popular option for companies is the traditional, fixed-term business loan, which allows people to borrow much more than they can with a line of credit. It works in a similar way to a mortgage – you borrow a lump sum and then pay it back over time. This is ideal for capital-intensive projects where you need a large cash infusion to get something off the ground.
Loans can also be secured or unsecured. A secured loan is when you put up collateral, such as a piece of equipment or a building, that a lender can then take possession of if you don't pay back the loan. Secured loans typically come with lower interest rates because it's less risky for the lender. If something goes awry, they can seize that asset to recoup any losses.
With unsecured, you don't have to put any assets up for collateral, but an institution may charge a higher rate for the additional risk.
How fast can you access the funds?
Once a lender approves you for a line of credit, you can usually start using it right away. But use the money wisely – it's easy to get deep into debt, to the point where it becomes difficult to pay the outstanding amount back. If you're only covering the minimum monthly payment, then the interest you owe will only keep growing.
Was a business line of credit the right move?
Usually, companies will have an idea as to what they want to use a line of credit for, but for many businesses, it just sits there until they need it. But if your business is thriving because of it, and you're able to pay it off in a reasonable time, then applying for one was the right decision.
As long as there are businesses operating in America, there will be lines of credit to help them manage their expenses and cash flow. It's a key tool in the entrepreneur's toolbox and one that can be a big factor in fueling business growth.
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The content of this article is provided for informational purposes only. You should always obtain independent business, tax, financial, and legal advice before making any business decision.
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