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Your Guide to Understanding Business Lines of Credit

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Updated September 11, 2020
Your Guide to Understanding Business Lines of Credit
When you own and manage a business, it’s important to have cash available. 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 2019 Small Business Credit Survey from Federal Reserve Banks, 55% of those surveyed said they regularly rely on loans and lines of credit to help fund their business operations. In fact, small business loans and small business lines of credit were the number one source of financing, outside of personal funds and business earnings.While lines of credit are fairly common, there are many questions business owners may have about how a business line of credit works, how to apply for one, how much credit they can get, and what qualifications are needed. 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. To help you out, we put together this guide, which includes the basics of what a business line of credit is, from the application process to interest rates and fees.

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 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 to some other types of financing like merchant cash advances or online small business loans.

Repayment Options for Business Lines of Credit

Each month, you can choose to pay the minimum balance on a line of credit or pay it in full. 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, which come with their own 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, which may be helpful if you anticipate needing access to funds for cash flow and small business expenses over a longer period of time. 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 than short-term options.
When comparing your repayment options for a 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. 

Difference Between a Secured and Unsecured Business Line of Credit

When you’re comparing lines of credit from lenders, check if they offer unsecured or secured lines of credit, or both. Depending on which you choose, you may find differences in the interest rates, terms, and credit limits available.

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. In the event 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. 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 greater 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 difficult 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. But what’s the difference?A 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 and pay them off on terms agreed upon between you and the lender (e.g. monthly payments). As the balance is paid off, 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.A 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. The account is closed and if you want another business line of credit, you will have to apply once again.Choosing between the two depends on your business’ needs. Because they are less risky to lenders, non-revolving lines of credit typically offer lower interest rates and higher credit limits, making them a great way to manage your debts and financial risk. However, it can also be more work applying for a new line of credit every time you close a non-revolving account. Revolving lines of credit ensure that cash flow is available, which may be useful for your business, especially if cash flow fluctuates regularly. Unfortunately, they can also carry higher interest rates because they are seen as higher risk compared to non-revolving. 

How Can a Business Line of Credit Be Used?

There are a number of ways you can use a business line of credit, which make it more flexible compared to 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 defined as 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 that are essential to remaining successful. Here a few common uses for a business line of credit:
  • Payroll
  • Rent
  • Operational expenses
  • Inventory purchases
  • Repairs and supplies
  • Marketing
  • Cash flow gaps as a result of seasonality or unpaid invoices

How to Apply for a Business Line of Credit

Getting a small business line of credit is a fairly simple process. Here are some steps to help you get started.

1. Determine if Your Business is Eligible for a Line of Credit  

You can always start applying for lines of credit to find out if you’re approved, but it may be helpful to know common business line of credit requirements. Generally, the less risk you present as a borrower, the better terms and rates you’ll receive. Here are 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. Good credit is typically that over 660. If you have no credit or weak credit, you may still be able to get a business line of credit from lenders who offer bad credit business loans and lines of credit. 
  • Revenue: Lenders will typically assess your business 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 and/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 personal stake in the success of your company.
  • Collateral: As mentioned above, collateral can be helpful in getting secured lines of credit with higher credit limits and lower interest rates. While not all lenders require collateral, you may find it easier to qualify for a business line of credit if you have assets  to offer as security.

2. Gather the necessary documentation

Applying for a business line of credit will likely require documentation to show your ability to fulfill lender requirements and repay the funds. To ensure you meet the application requirements for a business line of credit, gather the following documents:
  • Bank statements: Lenders usually want to see past bank statements for your business account to ensure that you are creditworthy and able to repay the line of credit. Some lenders may want only a few months of statements, while others, like traditional banks, may want up to one year of statements. 
  • Personal identification: Lenders need to verify your identity, which may include a driver’s license, social security number, education, criminal record, and proof of your full legal name.
  • Business financial statements: These may include P&L sheets, cash flow sheets, and balance sheets
  • Tax returns: Some lenders may want to see your tax returns, both personal and business, to assess eligibility. It’s helpful to have up to three years of returns.
  • Proof of collateral: If you are seeking a secured business line of credit, you may need to provide documentation that shows you have the collateral available. If you are applying for an unsecured business line of credit, you will not need proof of collateral.

3. Compare lenders and business line of credit options

After you gather documents and other important information, you’re ready to start exploring the top lenders for small business lines of credit. Here are a few different types of lending options:
  • Traditional bank: Traditional banks are popular choices because they typically offer favorable interest rates and business loan terms. It can also be more challenging to get approved because banks often prefer a long business history and significant revenue. If your business has an established relationship with a bank, that’s a good place to begin your search for a business line of credit. 
  • Credit union: You can also compare rates and terms at a credit union, which may offer lower rates due to their business structure, which is supported by its members. They are also tax-exempt and required to reinvest their profits back into their programs as opposed to paying shareholders or increasing profit like a bank.
  • Online lenders: If you need a business line of credit quickly and don’t have the credit or financial records required by a bank, an online lender may be a good option. Typically, you’ll be required to fill out an application and can usually expect to hear back within a few days. Keep in mind that online lenders may have higher interest rates and lower credit limits.
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.

Annual Percentage Rate (APR) 

Sometimes, it can be confusing to distinguish APR from interest rates, but there’s an important difference. The APR on a business line of credit represents the total cost of borrowing money from the lender. In other words, 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 APR provides a consistent benchmark for you to reference as you compare the overall cost of financing from different lenders. 

Interest Rates

The interest rate on a business line of credit is the fixed or variable rate applied to your principal balance. Ultimately, it is the interest rate and your outstanding balance–not the APR–that 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 over looking at the APR. Keep in mind that interest rates on business lines of credit can be relatively high compared to other forms of financing. Though, interest only accrues on what you haven’t repaid. When deciding whether a line of credit is right for your business, consider honestly whether you’ll be able to make the monthly payments. If not, you could find yourself having to repay a balance plus interest that adds up to more than your budget allows. 

What Fees Apply to a Business Line of Credit?

While a line of credit may typically have fewer fees than a loan, it’s important to check for any additional costs when comparing lenders. Sometimes the interest rate may be very attractive, but the lender could tack on costs like annual fees that make it more expensive in the long-term. Here are some common fees associated with a 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 small percentage of the total loan.
  • Late fees: If you’re late on payment or miss it completely, you may be charged a late fee. Check with your lender for their specific late fee amounts and policies.
  • Annual fees: Some lenders may apply annual fees that vary depending 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 that is 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. Check with each lender to see if they have these fees and what they are.
  • Termination fees: Check with lenders to see if they 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, which are typically a percentage of the loan principal. When it comes to business lines of credit, you will also find that some lenders don’t penalize for early repayments.

Additional Financing Options

A business line of credit can be a great option to maintain cash flow and take care of short-term business expenses. But if you need long-term financing for big ticket items, there are other financing options that may be more suitable than a small business line of credit. These include:
  • Invoice factoring: Invoice factoring uses unpaid invoices as collateral to receive a cash advance from your lender.
  • Inventory financing: Used to pay for products that will be sold at some time in the future. The inventory acts as collateral for the loan.
  • Equipment financing: Used for the purchase of machinery, vehicles, or other business-related equipment. 
  • Personal loans: Personal loans are based on your personal credit history (not business credit). You may be able to use a personal loan for business purposes, however, some lenders prohibit it. 
  • Commercial real estate loans: For the purchase of a building for business use such as office space, a retail shop, or any other commercial function.
  • Business credit cards: Similar to small business lines of credit, these are great for short-term business needs. Business credit cards use a revolving line of credit with interest only charged on unpaid balances from previous billing cycles.
  • Online loans: Online lenders offer similar loan options as traditional banks, but typically have a faster approval process and may offer more options for people with lower credit scores.

Compare Lenders in One Simple Step

Whether you need to know what an SBA loan is, how to apply for a business loan, or simply want to apply for a business line of credit, you deserve to know all your options. At Lantern Credit, 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 get access to some of the top small business financing options from top lenders. No guessing, no waiting. Whether you’re just starting out, or you have a rapidly growing business, we’ve got solutions for you.

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 information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.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.Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.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.