It’s impossible to know what tomorrow will bring when you’re a business owner. Business needs can change at the drop of a hat. Today you need to buy two hundred folding chairs, tomorrow you need to hire a half-dozen new employees, and the next day you have an opportunity to buy a year’s worth of inventory at a steep discount.
When those short-term opportunities arise, your business needs to have a line of credit. Business financing can be a slog, and lines of credit are a fantastic way to make sure you’re always able to make moves when the need arises.
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What is a business line of credit?
It’s perhaps easiest to think about a business line of credit in comparison to a more traditional term loan.
When you take out a loan, the process is straightforward. You apply for a particular amount of money through a financial institution. The lender goes over the borrower’s financial history, credit scores, business credit scores, and existing debt. The lender then either denies the loan or approves it. If the loan’s approved, there’s an agreed-upon interest rate, and the borrower repays the loan using monthly payments. A traditional term loan is what you picture when you picture a loan.
So now that we know what a business line of credit isn’t, we should discuss what it is.
Simply put, a business line of credit is very similar to a business credit card. The beginning of the process is similar to that of a term loan. There’s the application process, the inspection of credit scores, and a decision is made.
But unlike a loan, a line of credit doesn’t see a large sum of money hit the bank of the borrower. Instead, the borrower has a credit limit and can withdraw money up to that limit. And on top of that, they only need to make payments on what is withdrawn. There are also likely to be additional fees like maintenance fees, origination fees, and annual fees, so bear that in mind as well.
Why is a business line of credit helpful?
Business lines of credit are essentially a protector against the unexpected. The problem with traditional small business loans is that they’re deposited as lump sums and payments are often quite substantial due to the size of the loans. If you are approved for a loan of $250,000, you will start making payments (including interest payments) on $250,000. This type of financing can be helpful in many cases, like when you’re a new business with a substantial amount of inventory or space to purchase.
But what if you don’t need that much? What if you need to make a smaller purchase but are having season cash flow issues? What if an essential (and expensive) piece of equipment breaks, and you don’t have the time to be out of commission while you apply for financing options that take longer to apply for and receive? If you own a restaurant and your industrial freezer breaks down, that needs to be solved immediately.
With a business line of credit, that working capital is always available to you. If you’ve got that same $250,000 in available credit, you can make a $10,000 purchase today, replace a $40,000 piece of equipment next week, and make a substantial real estate purchase later on, all while only paying interest on what you’ve borrowed. You’ll only pay interest on what you spend.
How to Get a Business Line of Credit
Much like applying for any other loan, business lines of credit require a significant amount of documentation to prove to potential lenders that you’re a trustworthy borrower. In order to make sure you’re getting the best possible repayment terms, there are a few things you’ll need to have on hand:
- Financial Statements. A loan is effectively a financial institution’s way of making a bet. They’re betting that you, the small business owner, will be able to pay back their loan with interest. The easiest way to show that you’re a smart bet is to carry good credit. Your financial statements are an important way lenders are able to evaluate your business’s financial history to see how safe of a bet you are. You’ll need to show annual revenue, your business expenses, statements from your business checking account, your business credit history, tax returns, your balance sheets… anything that will show the lender that your company makes money – which will translate into the lender making money.
- Personal documents. You’ll need to provide a driver’s license or other form of government-issued ID, of course. But you’ll likely need to provide your personal credit score, bank statements, and other forms of personal history. Again, the lender will want to see that they’re lending money to someone who’s responsible and has a history of paying back their creditors.
- Business documents. You’ll need to show your articles of incorporation, licensing as appropriate, maybe even your business plan.
- Proof of collateral. Like with other loans, you can generally find yourself with a lower interest rate by providing collateral to the lender. If you offer up your business real estate, for example, the lender can repossess that collateral in case you fail to repay the loan. In some cases, there will be no physical collateral. Instead, you may have to sign a personal guarantee, meaning that in the case of your company failing to pay back a loan, the lender can come after your personal assets.
Types of Business Lines of Credit
There are a few different options available for business lines of credit. You’ll first need to decide your ideal lender.
Traditional Lenders vs. Online Lenders
As with many financial products, you’ll be able to decide between a traditional brick-and-mortar bank or an online lender.
Traditional banks and credit unions do have some upside for business owners looking for a line of credit. They’re likely to be able to offer lines of credit with higher credit limits and at lower interest rates. However, they’re able to offer those benefits due largely to the fact that their borrower requirements will be more stringent. They’ll have higher credit score requirements in exchange for those lower interest rates.
Traditional banks will also be more likely to require physical collateral as part of the line of credit. That collateral can be real estate, inventory, or accounts receivable.
Online lenders, on the other hand, will typically have smaller loan amounts, higher interest rates, and lower minimum credit scores required for their borrowers. The application process is typically much faster, and the turnaround for funds can be as quick as a single business day.
Secured vs. Unsecured
Once you’ve decided where to seek your business line of credit, next consider whether you’re willing to put up collateral.
A secured line of credit means that you’ve offered up some asset as collateral for the line of credit. That collateral could be accounts receivable, a real estate holding, inventory, or equipment. If you default on your line of credit, that collateral will be repossessed by the lender.
In an unsecured business line of credit, no such physical collateral is necessary. However, you’ll likely face larger interest rates, and even though there may be no collateral, some unsecured lines of credit will require a personal pledge, meaning that a lender can come after your personal assets in the case of default.
Whether you’re a startup or you’ve been in business for years, keeping an eye on loan options and other sources of funding is key to running a small business. It behooves any company to seek out a small business line of credit because the best business lines of credit give business owners an ace in the hole. A failsafe if an unexpected financial need arises which doesn’t require any sort of up-front payment.
You never know what’s going to happen in the future. Having a business line of credit can help make sure that when the opportunity or need arises, you can ensure success for your company.