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Your Guide to Understanding Business Lines of Credit

Your Guide to Understanding Business Lines of Credit
Lantern

Lantern

Updated February 9, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
When you own and manage a business, it’s crucial to have cash available. However, when cash flow is running low and you need to pay bills or make small business purchases, a business line of credit can be a good option for filling in the financial gaps.According to the 2020 Small Business Credit Survey from Federal Reserve Banks, 54% of those surveyed said they regularly rely on small business loans and lines of credit to help fund their business operations.Whether you’re just starting out or you’ve been established for years, it’s important to know your options when it comes to a business line of credit (LOC). To help you, we put together this guide, which includes the basics of:

What Is a Business Line of Credit?

A business line of credit, sometimes called a commercial line of credit, offers you a convenient, flexible way to cover expenses like working capital, bills, inventory, and other small, last-minute expenses. Unlike a personal loan or long-term business loan, a line of credit gives you access to a maximum amount of funding with interest only charged on the amount you borrow, rather than on the entire amount available. You can borrow from your small business line of credit and repay as needed, as long as you don’t exceed the approved credit limit.  If the balance is paid off monthly, a line of credit can be a very affordable way for business owners to maintain cash flow, since you’re only borrowing what you need and paying interest on remaining balances, not the entire credit limit. And the cost of starting a business line of credit can be relatively low compared with some other types of financing like merchant cash advances or online small business loans. 

How Does a Small Business Line of Credit Work?

A small business line of credit is similar to a credit card, but interest rates are usually lower, and the funds must be used for business purposes.Once you open your line of credit, you can use the money for whatever you need so long as it's for your business. The lender then expects a minimum repayment plus interest every month, just as a credit-card company would.Diagram showing how a business line of credit worksTo make this a bit more concrete, imagine you own a business called XYZ Retail. Your business is ready to expand, but you don't have the cash on hand to take care of all your needs. So you open a business line of credit with an approved limit of $100,000.Knowing you'll be charged interest on what you owe, you focus on immediate supply needs rather than spending the full $100,000. These are the things impeding your business's efficiency, like outdated computers and too few shelves.You ultimately spend $20,000 that month, then pay $10,000 plus interest to the lender the next month.As your immediate needs are covered, you decide to hold off on additional purchases and don’t use your business LOC to buy anything in month two. Instead, in month three, you repay the remaining $10,000 plus interest.Now, your business line of credit debt is fully paid off. If it's revolving, you still have access to the money when needed. (More on that later.)

Repayment Options for Business Lines of Credit

Often you can choose to pay the minimum balance on a line of credit, pay off the total amount, or do something in between each month — much like a credit card. However, lenders may have specific repayment terms to keep in mind. For starters, your business line of credit may come with a draw period. The draw period is a specific amount of time you can borrow funds from your line of credit. If applicable, it will precede the repayment period, during which you need to finish repaying the funds you’ve borrowed. When it comes to repayment, you may have short- or long-term options, each of which comes with pros and cons:
  • Short-term repayment plans typically span 6 to 12 months. 
    • Because the repayment period is shorter, the interest rates may be higher, but you could end up paying less overall compared to a long-term line of credit. 
    • Additionally, if you’re short on time, applying for a short-term line of credit with an online lender may yield a faster turnaround time compared to long-term lines of credit. 
  • Long-term repayment plans can exceed 12 months. 
    • Because the lender takes on more risk with a long-term line of credit, the application and approval process for these business lines of credit may be more rigorous.
    • May be helpful if you anticipate needing access to funds for cash flow and small business expenses over a longer period. 
When comparing your repayment options for a small business line of credit, you’ll also want to consider whether you need a secured or unsecured line of credit, as well as a revolving or non-revolving line, both of which can affect the terms offered by your lender. 

Costs of Using a Small Business Line of Credit

When deciding whether a line of credit is right for your business, consider whether you’ll be able to make the monthly payments — meaning you need to look at both the interest rate and annual percentage rate (APR), which includes fees.  Interest rates and APRs are easily confused with each other, so let's break them down.

Interest Rates

The interest rate on a business line of credit is a percentage of your principal balance, which can be a fixed or variable rate. Ultimately, the interest rate and your outstanding balance — not the APR — determine your monthly payments. If you plan to use a line of credit for less than a year, looking at the interest rate may be more helpful in calculating your total costs.  Keep in mind that interest rates on business lines of credit can be relatively high compared with other forms of financing. However, interest only accrues on what you haven’t repaid.  

Annual Percentage Rate (APR) 

The APR is the interest rate determined by the lender plus additional fees and costs (e.g., annual fees, opening fees, payment processing fees, etc.) — the total cost of borrowing money from the lender. This rate provides a consistent benchmark for you to reference as you compare the overall financing costs from different lenders. 

What Fees Apply to a Business Line of Credit?

While a small business line of credit may typically have fewer fees than a loan, it’s essential to check for any additional costs when comparing lenders.  Sometimes the interest rate may be desirable, but the lender could tack on costs that make business LOCs more expensive in the long term.  Here are some common fees associated with business lines of credit: 
  • Origination fees: Lenders may charge a fee for processing your business line of credit application. The origination fee may cover other costs, like underwriting and processing fees, and is usually a percentage of the total loan.
  • Late fees: If you’re late on a payment or miss it completely, you may be charged a late fee. 
  • Annual fees: Some lenders may apply yearly fees based on the amount of your line of credit. For example, if you have a maximum credit limit of $25,000, you may have an annual fee less than if your line of credit was over $25,000.
  • Cash advance fee: Some lenders may apply a fee if you ask for a cash advance, which may be a flat rate or a percentage of the cash advance. 
  • Upfront and renewal fees: Your lender may charge these fees when you apply for a new line of credit or renew an existing one. 
  • Termination fees: Some lenders charge a fee for ending your line of credit before the full term is over. This is typically a percentage of the line of credit.
  • Prepayment fees: If you pay down your balance early, some lenders may charge prepayment fees, typically a percentage of the loan principal. 
Remember, every lender has its own rules. You should clarify every possible cost before signing any paperwork.

Lenders Who Offer Business Lines of Credit

Curious about where to get a small business line of credit? Here are a few lenders to help you jumpstart your search.Remember: As stated above, Lantern does not endorse any product. This is strictly informational.

Difference Between a Secured and Unsecured Business Line of Credit

When you’re comparing business lines of credit from lenders, check if they offer unsecured or secured lines of credit — or both. You may find differences in the interest rates, terms, and credit limits available.Let's dig into these two types of business lines of credit in more detail.

Secured Lines of Credit

A secured line of credit uses an asset you already have, like company real estate, as collateral to secure the loan. If you default on payments, the lender has the right to seize that piece of collateral to offset their losses. In general, a secured line of credit puts the lender at less risk, which can result in more favorable terms for you. In addition, the benefit of choosing a secured business line of credit is that they typically carry lower interest rates and may offer higher credit limits, depending on your lender.  Certain types of collateral may also help you secure financing more easily. Bigger ticket items like real estate offer more security to the lender, but that also means you’re leveraging important collateral. If you’re concerned about defaulting, unsecured business lines of credit may be a better option.

Unsecured Lines of Credit

With an unsecured line of credit, the lender is taking on a more significant risk by offering you financing. If you default, there is no collateral to recoup the losses.Since this puts the lender at greater risk, an unsecured line of credit may be more challenging to obtain and carry higher interest rates. The higher rates and lower credit limits are a way for lenders to protect themselves from potential losses.

Revolving vs. Non-Revolving Lines of Credit

When you choose a business line of credit, you may be presented with two options: a revolving or non-revolving line of credit.

Revolving Line of Credit

revolving line of credit is one in which the lender offers a set amount of credit that’s available up to the established limit. You can use the funds for ongoing business expenses. If you pay it off entirely, the credit limit doesn't go away, and you can continue to borrow up to the credit maximum.For example, let’s say you have a business line of credit with a limit of $100,000. You purchase supplies for your business that cost $20,000, so you still have $80,000 available to spend. A month later, you pay back $10,000 (without spending anything additional), so you now have $90,000 available to spend. One month later, you pay back the remaining $10,000 and have the full $100,000 available to spend. This is similar to a credit card, except that money is put directly into your business account up front, giving you access to ongoing cash flow. 

Non-Revolving Line of Credit

non-revolving line of credit is very similar to revolving, except that the line of credit cannot be used after it’s spent and paid in full. After that, the account is closed, and if you want another business line of credit, you have to apply again.So, for example, let’s say you own a restaurant and your walk-in freezer breaks. You need to replace it ASAP. You apply for and are approved for a non-revolving line of credit with a $30,000 limit. You purchase a new freezer for $20,000 and pay back that amount plus interest over the next few months. You now have $10,000 left on your business LOC to use towards a future expense.  Let’s say your commercial oven breaks. You use your line of credit to purchase a new one for $10,000 and will pay back the amount plus interest over the next few months. At this point, you’ve used up your non-revolving business line of credit.

How Can a Business Line of Credit Be Used?

There are several ways you can use a business line of credit, making it more flexible than purpose-specific funding like equipment financing or commercial real estate loans. For many business owners, a line of credit offers cash flow to cover short-term working capital expenses. Working capital is the difference between your current assets, including inventory, cash, and accounts receivable, and what your business is still liable for. When working capital is positive, you have a better ability to expand. If working capital is low or negative, you may find it helpful to receive funding to cover expenses essential to remaining successful. Here are several common uses for a business line of credit:
  • Payroll
  • Rent
  • Operational expenses
  • Inventory purchases
  • Repairs
  • Supplies
  • Marketing
  • Cash flow gaps

How to Apply for a Business Line of Credit

Applying for a business line of credit is similar to applying for most types of small business loans. Here are some steps to help you get started. 

1. Determine if a Small Business Line of Credit Is Your Best Option

Before you begin the application process, decide if a small business line of credit is the type of financing you need. Compare business loans to LOCs to determine what’s right for your needs and qualifications. Similar to getting short-term business loans, long-term loans, and other types of financing, business lines of credit have associated interest rates and possible fees. When you’re considering your funding options, remember to factor in these costs.If you decide a line of credit is your best option, then read on. If not, we detail other funding options further down this page.

2. See if Your Business Is a Good Candidate for a Line of Credit

Generally, the less risk you present as a borrower, the better terms and rates you’ll receive. Here are some of the factors lenders may consider when weighing your application for a business line of credit: 
  • Credit score: Check your personal and business credit scores. The higher your score, the better options you may have regarding credit limits and interest rates.
  • Revenue: Lenders typically assess your monthly and yearly revenue to determine how capable you are of paying back your line of credit. If they see consistent growth, they may be more likely to lend to you or increase your line of credit.
  • Personal investment: Lenders may also look at what you have invested in the business because it shows that you have a personal stake in your company's success.
  • Collateral: Collateral can help get secured lines of credit with higher credit limits and lower interest rates. 
  • Age of business: Lenders often prefer established companies — the longer you've been open, the better your rates, terms, and possibility of approval may be. 

3. Compare Lenders and Business Line of Credit Options

 As you start exploring lenders for small business lines of credit, think about those which your business and credit profile would be the best candidate for.  Here are a few different types of lenders to look at:
  • Traditional banks: Traditional banks typically offer favorable interest rates and business loan terms, but they often prefer a long business history and significant revenue. 
  • Credit unions: Credit unions may offer lower rates due to their business structure, which their members support. They are also tax-exempt and are required to reinvest profits back into their programs.
  • Online lenders: If you need a business line of credit quickly and don’t meet typical qualifications, an online lender may be a good option. However, online lenders may have higher interest rates and lower credit limits than other possibilities.

4. Gather the Necessary Documentation

Once you have narrowed down your list of lenders, collect all documents you need to apply for their business lines of credit. This information should be clearly outlined on their websites.  To ensure you meet the application requirements for a business line of credit, you typically need to provide the following documents:
  • Personal identification: Lenders need to verify your identity, which may include a driver’s license, social security number, and proof of your legal name.
  • Business financial statements: Any financial statement you can think of that may be required, including bank statements, balance sheets, tax returns, projections, and more.
  • Business plan: While business plans are typically associated with grants, some line of credit lenders may want to see them, too.
  • Legal documents: All proof that your business operates according to local, state, and national laws, such as business licenses, may be needed.
  • Proof of collateral: If you want a secured business line of credit, you may need to provide documentation that shows you have the collateral available.

5. Apply for a Small Business Line of Credit

Now that you have all the documents you need to apply, it's time to go for it. Some lenders, particularly online ones, may allow you to pre-qualify for a small business line of credit. Pre-qualifying means you can be given a reasonably accurate idea of your terms and rates without dealing with credit scores being run. However, pre-qualifying isn't especially common with lines of credit — you likely need to choose your best option ahead of time to potentially lower any financial risk associated with having multiple hard credit checks.Make sure you fill out the application fully and accurately, checking all details before submitting it. Don't be afraid to ask questions as you go.

Alternate Financing Options to a Business LOC

A business line of credit can be an excellent option for maintaining cash flow (revolving) or taking care of short-term business expenses (non-revolving). But other financing options may be more suitable than a small business line of credit, depending on your situation. These include: 
  • Invoice factoring: Invoice factoring uses unpaid invoices as collateral to receive a cash advance.
  • Inventory financing: This is used to pay for products to sell in the future. The inventory acts as collateral for the loan.
  • Equipment financing: This type of financing pays for machinery, vehicles, or other business-related equipment. 
  • SBA loans: These loans are backed by the U.S. Small Business Administration and offered by banks and approved lenders. 
  • Personal loans: Personal loans are based on your personal credit history. You may be able to use a personal loan for business purposes, but some lenders prohibit it. 
  • Commercial real estate loans: These loans purchase buildings for business use.
  • Business credit cards: Business credit cards use a revolving line of credit with interest charged on unpaid balances from previous billing cycles.
  • Online loans: Online lenders offer similar loan options to traditional banks but typically have a faster approval process and may provide more opportunities for people with lower credit scores.

Compare Lenders in One Simple Step

At Lantern by SoFi, we’re here to help simplify the process of finding financing, so you have more time to manage your business. All you have to do is fill out one simple form to access some of the top small business financing options from top lenders. No guessing, no waiting. Whether you’re just starting or you have a rapidly growing business, we’ve got solutions for various business loan purposes. Compare small business lenders today.
Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website on credit (https://www.consumer.ftc.gov/topics/credit-and-loans)The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC20007

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Lantern

Lantern

Lantern is a product comparison site that makes it easy for individuals to shop for products and compare offers with top lenders. Lantern is owned and operated by SoFi Lending Corp., the digital personal finance company that has helped over one million people get their money right.
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