The number of financing options out there for small businesses can feel a little overwhelming. Let’s take a minute to look at one of them: the business line of credit.
How It Works
Many business financing options provide you with a lump of money upfront. While seeing your bank account suddenly shoot up is an exhilarating sensation, you might not actually need all of that money at once. Credit lines operate similarly to credit cards–you borrow money only as you need it. You can continuously pay into and withdraw cash from your credit line, keeping it open as long as you don’t exceed your limit and make required payments regularly.
Because they both offer so much more flexibility than other financing tools, many companies facing certain situations wind up picking between cards or lines as their best options. If you predict an upcoming very large, one-time expense, then you may be a better candidate for a loan than for a line of credit. Credit lines are more for dealing with unexpected costs or day-to-day cash flow management, such as when you need to pay company payroll on Friday but won’t receive a major invoice payment until Monday.
Because you’re only paying interest on what you’ve taken out of the line of credit in the first place, you might wind up paying substantially lower interest than you would with a business loan. This makes credit lines a lot more flexible for long term backup sources of financing–you can keep your line paid off for most of the year and only dip into your line when you need a one-time cash expenditure. While business loans require re-applying (and all the paperwork and hoop-jumping that entails) whenever you need more money, you can use your established line of credit whenever you want. If your business faces an unexpected cash emergency, you might be particularly glad you have one.
While they share credit cards’ flexibility, lines of credit generally have lower interest rates and higher credit limits. This means you’re less likely to fall into the death spiral of increasing credit card interest making payments harder and harder. Of course, if you show a lender that you can’t manage your line well, they may increase your interest rates–but you still will pay less than you would with a card. Some lines of credit also allow you to make interest-only payments, rather than minimum repayments plus interest. While it’s not a great idea to leave a lot of your line tied up for long, this feature can be helpful if you face an unexpected cash crunch.
If your business regularly makes payments that can’t be covered on a credit card, such as payroll, then a credit line would be a better fit. While credit cards usually charge high fees for cash advances, everything you take out of a credit line is by default cash.
Most banks require a confidence-inspiring track record before handing out lines of credit. The same conditions that discourage banks from investing in small businesses through loans also disincentive offering lines of credit–after the 2008 financial crisis, many banks decided to focus on lending to larger companies who provided a greater return on investment. And just like applying for a loan, credit lines from traditional banks usually require paperwork-heavy, old-fashioned credit application procedures that can drag on for quite a while. Because credit lines provide a more unpredictable profit stream for banks than loans (due to the above-mentioned flexibility), some banks may make them even harder to acquire. Online business lenders are sometimes less exacting when requiring track records and documentation, but they also tend to have higher interest rates.
Lines of credit are sometimes secured with collateral, which means you might have to give up a major asset, such as your house or storefront, if you can’t make payments. There’s a personal risk involved, but for some applicants a secured line of credit may be the only option to convince funders to take a chance on them.
If you’re still trying to decide between a line of credit and a credit card, you might want to consider rewards. Some business credit cards provide cashback on your purchases–these small rewards can add up to provide some cushion for your business’s expenses. Credit lines work very similarly to credit cards in a lot of ways–but they don’t offer rewards.
Lines of credit often require annual renewal, which is a less intensive process than total re-application but can still result in your line getting reduced or even withdrawn if the lender chooses. This adds a degree of unpredictability to credit lines–while your loan repayments have a set timeline that your lender can’t unilaterally decide to speed up, a credit line lender has the power to regularly alter the amount lent. This is why it’s important not to build up a lot of debt on your line–if it’s abruptly recalled or reduced, you need to come up with a lot of cash, fast.
If you’d like to receive additional advice regarding how a business line of credit might help your company, please reach out to a Currency team member here.