Business Line of Credit
A bank overdraft can help your business with short term cash-flow needs such as making critical payments to suppliers that cannot be deferred. When you forecast a longer – or higher - shortfall in your cash flow, a loan is usually a preferred option than an overdraft. A business line of credit can help you with these longer – and higher – shortfalls while still keeping the flexibility of an overdraft facility.
What is a business line of credit?
A business line of credit puts a sum of money at your disposal, you draw money when you need it, up to the amount you have agreed with your lender. The money is repaid in lump sums instead of regular payments as in a business term loan. As you repay the money you have withdrawn, that sum becomes available to you again, up to the agreed limit. A business line of credit works like an overdraft on your bank account, except it is not tied to a pre-existing bank account (although the lender can create a bank account to manage it for convenience).
Applying for a business line of credit
Like any other purchase, it is important to shop around for a service that suits your business and needs. Many lenders offer business lines of credits. The conditions to apply are usually based on:
- A turnover higher than a specified amount
- A minimum credit score
- Having been in business for at least a certain period
Company turnover, credit score, and length in business vary from lender to lender, most companies would ask for a set of financial accounts for the relevant period they require.
These are not the only things you need to consider when you shop around. The interest rate and how and why it may change are also something worth looking at. The costs can creep up if your credit is not very strong. This is one of the main disadvantages of a business line of credit compared to a business term loan.
Advantages of a business line of credit
Flexibility is the main advantage of a business line of credit. For traditional business loans, the full amount is disbursed to your bank account. With a business line of credit, you drawdown only what you need at that moment, rather than having a large lump sum sitting in your account, which you may not fully use. A business line of credit typically charges interest only on what you use, so this allows for significant cost savings.
The amount of credit that was granted when you sign up for a business line of credit represents the maximum amount the lender is prepared to give you, and is the maximum amount you can drawdown. The line of credit ends when the contract ends, until then what you repay lowers the amount of interest you are charged and becomes immediately available to you. In that sense, it works like an overdraft.
We mentioned above that your credit score is one of the criteria most lenders use before granting you a business line of credit. Some lenders may accept a poorer credit score as well. In any case, if you use your line prudently and make payments you can afford as soon as possible, a business line of credit can be a great tool to improve your credit score.
Many lenders approve a business line of credit faster than a business term loan of the same amount; also business term loan may coexist with a business line of credit provided you have taken out the business term loan were never late with your repayment.
Secured or unsecured?
Some lenders may require collateral. A secured business line of credit can be a drawback for some business owners but the interest rates are usually lower. Also, a poor credit score may be less of a hindrance because the collateral secures the loan. In case of default, the lender can seize the collateral to liquidate the outstanding amount of the line of credit.
An unsecured business line of credit does not require any collateral. Usually, the interest rate is higher and the minimum level of credit score requested by the lender is also higher.
Business line of credit vs. corporate credit card
A corporate credit card can be considered a form of business line of credit, except the limit is almost always lower, it requires monthly payment and the interest rate is usually higher. Although they both represent line of credits, a corporate card and business line of credit should not be compared. They are different tools for different purposes. A corporate card is a useful instrument to pay for purchases, the credit granted is very short term at a high cost, higher than an overdraft. A business line of credit is a tool to cover for systemic or exceptional cash flow issues, for instance, being able to use the sums of money you have billed before your clients pay you.
Business line of credit vs. invoice finance
If the only reason to apply for a business line of credit is that you cannot (or would not) wait for your clients to pay you, you can also explore invoice finance. Although invoice finance is directly tied to the amount you have billed. If you need to increase your working capital for a higher sum than the total you have billed that month, invoice finance may not be sufficient since they would not go higher than a certain percentage of the value of the invoices you have submitted for funding.
Advantages of a business line of credit for SMEs
A business line of credit is particularly suitable for SMEs that can meet a lender’s eligibility requirement and need flexible financing to manage short-term cash flow pressure, increase working capital, or cover unexpected expenses. A business line of credit allows SMEs to borrow what they need, for as long as they need and make irregular lump-sum payments provided they do not exceed the total amount agreed with the lender. Maintaining a line of credit in good standing may help build your business credit rating and position your business for better loan terms if you see future financing needs. Many small business experts suggest that first-time applicants should start a modest line of credit and pay off the debt quickly as a way of building a credit profile.