How To Know If A Line Of Credit Makes Sense For Your Business

April 6, 2021

Are you a small business owner? Are you looking for a ready source of capital to meet either anticipated or unexpected expenses? Are you familiar with what’s known as a business line of credit?

If your answer to the first two questions is “yes,” but your response to the third is “no,” read on to learn more about a business line of credit. This lending product can help you meet your present needs while giving you the flexibility to negotiate any financial challenges that may arise in the future.

What is a business line of credit?

A business line of credit is a revolving line of credit that provides your business with a fixed amount of money. You can use this money to cover short-term operating expenses, such as meeting payroll or paying suppliers.

How can I secure a business line of credit?

You can secure a business line of credit through a bank, a credit union, or a commercial lender.

How does a business line of credit work?

You are free to use as much money as you need to support your business, up to the limit of your line of credit. The portion you have withdrawn from the line of credit is considered a loan, and you pay interest only on that amount.

For example, if your line of credit is $100,000 and you withdraw $20,000, you pay interest on that amount only. No interest incurs on the remaining $80,000.

As you pay back what you’ve borrowed, you can borrow more cash as needed — and up to your credit limit — without having to apply for another loan.

How do I access funds available to me via a business line of credit?

You can transfer funds from your line of credit to your checking or savings account online, via phone, or using a debit card or checkbook issued by your lender.

What’s the difference between a secured and an unsecured business line of credit?

When applying for a secured business line of credit, you must put up assets such as inventory or property as collateral. If you fail to pay your lender back, they can take possession of these assets.

An unsecured business line of credit does not require collateral. However, some lenders may require a personal guarantee or impose a lien on your business assets as part of the application process.

What is a personal guarantee?

A personal guarantee gives the lender the right to seize your personal assets, such as your home, should you fail to pay back the cash you’ve borrowed.

What is a lien?

A lien entitles your lender to seize your business assets in the event that you cannot repay.

When seeking a business line of credit, always ask potential lenders whether they require collateral, a personal guarantee, or a lien so that you can identify the lending option that makes the most sense for your business.

How do business line of credit terms compare to business loan terms?

Again, a business line of credit is a revolving line of credit. Once you draw from it, you can either repay the balance in full or whatever amount you can afford. As long as you make the required minimum payment, your account will remain in good standing. As noted above, your lender will not charge interest on the unused portion of your line of credit.

By contrast, a business loan — sometimes called a term loan — provides small business owners with a lump sum. Small business owners draw down the total of their loan all at once, then pay it back over time, plus interest. Because a business loan is a form of installment credit, you must begin repaying the loan right away via fixed monthly payments — even if you haven’t started using the money.

A business loan may be either a long-term or short-term loan. Long-term loans are most appropriate for when you need to finance a major project, such as purchasing a new building, remodeling an existing facility, or upgrading machinery and equipment. These loans must typically be repaid within three or more years.

Short-term business loans are generally available in smaller amounts than long-term loans. They are most useful for addressing your immediate capital needs, such as purchasing inventory or paying employees and rent during a business downturn. Short-term loans typically must be repaid within 6 to 24 months.

If you make at least your monthly minimum payment and stay under your limit, you can use your business line of credit for as long as permitted under the lender’s terms.

Additionally, most business loans are limited to specific purposes. For example, if you borrow money to cover the costs of new construction but accept a bid that comes in under budget, you can’t use the overage to pay your employees. Meanwhile, you can use a business line of credit to pay for any business-related expenditures of your choosing.

Finally, business loans are generally for larger amounts than business lines of credit. Consequently, they’re also more likely to require collateral and come with stricter application requirements.

How much interest should I expect to pay on my business line of credit?

Many factors affect the interest rate quoted on a business line of credit. Among them are:

  • The credit limit for which you are applying.
  • Your personal and business credit scores.
  • Your lender’s specific offerings.
  • Market conditions.

That said, many institutional lenders key their interest rates to the prime rate — the interest rate that banks offer to the customers they believe to be at the lowest risk of defaulting on their obligations.

You should consider any business line of credit interest rate quoted at or near the current prime rate to be exceptionally favorable. Rates quoted far in excess of the prime rate may indicate that your business is not quite ready to assume additional debt.

The Wall Street Journal calculates this prime rate based on data it collects from individual financial institutions. You can view the current prime rate and learn more about how it is calculated by visiting the Journal’s website.

As of this writing (March 2021), the most competitive interest rates on business lines of credit fall within a range as low as 7 percent and as high as 25 percent. For reference, the average interest rate on a Small Business Administration (SBA) 7(a) loan is approximately 7 percent.

How can I decide which is better for my business: a loan or a line of credit?

Deciding on whether to apply for a business line of credit or a business loan depends on several factors.

  • How much capital do you need? Business lines of credit usually do not exceed $250,000. If you need to borrow above that total, a business loan may be the better option.
  • What do you hope to do with the money your borrow? If you have a specific purpose in mind, you may be able to secure more favorable terms by applying for a loan designed for that purpose. If you are most in need of discretionary funds, you may be able to secure friendlier terms via a line of credit.
  • Which is more valuable to you: predictability or flexibility? If it’s predictability you want, a business loan with fixed monthly payments and a fixed interest rate can make it easier to budget for your business. If you desire flexibility, a business line of credit that permits more adjustable monthly payments may be the better option.
  • How good are your business and personal credit scores? Lower credit scores may limit your line of credit (or loan) amount and interest rate options.
  • Do you need to build your business credit score? If so, securing a business line of credit, using it, and paying it down can help a new business establish its creditworthiness. Doing so can be a big help as your financing needs grow along with your enterprise.

In comparing your options, we should add a word of caution: not every business opportunity is a good one. It can be surprisingly easy to borrow too much against your line of credit and spend too much of your profits on interest payments. You should consider applying for a business line of credit only if you have the discipline and the financial infrastructure to avoid this kind of spending hazard.

How do I qualify for a business line of credit?

Most institutional lenders, such as banks, ask that businesses show proof of a healthy revenue stream to qualify for a line of credit. Your business may also need to have been in operation for a few years to qualify.

Lenders may or may not set a minimum credit score. However, borrowers typically need a personal credit score of 500 or higher to qualify for a line of credit. (Business credit scores are calculated differently. You can learn more about business credit scores here.)

Lenders typically require that applicants for a business line of credit furnish the following documents.

  • Personal and business tax returns.
  • Bank account information.
  • Business financial statements, such as a balance sheet or a profit-and-loss statement.

Commercial lenders who offer fast applications and approvals often advertise more lenient rules for qualification. However, they are likely to charge higher interest and offer lower credit limits than institutional lenders.

If you’re ready to apply for a business line of credit, we hope you’ll choose Guaranty Bank & Trust. We have over 100 years of experience providing hard-working, entrepreneurial Texans with access to working capital. Visit any of our 30 convenient locations or book a video appointment with one of our bankers today to learn how our community-focused services can help you grow to meet your business goals.

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