A business line of credit (LOC) is a flexible loan between a financial institution (eg, a bank) and a business. You get access to cash up to a preset limit, as and when you need it, to be used on whatever you see fit. And you pay interest only on the amount you've borrowed, rather than the full limit. It's typically a ‘revolving’ arrangement – that means you can keep borrowing money up to the limit and paying it back during the agreed-upon time frame (often a year), without the need to reapply.
The lender evaluates your business and the risks involved, and then decides how much you can borrow, the interest rate and the repayment terms. The range of LOCs can be big – from $5,000 to $150,000 – but finance marketplace Fundera says that the average short-term LOC for small businesses is around $22,000. LOCs are either secured (guaranteed by some kind of collateral, like a car or a home) or unsecured (not guaranteed by any personal asset).
Why it's important
This is a super-popular type of short-term funding for small businesses and a pretty essential tool in your funding toolbox. For many small businesses, cash flow is likely to be a constant concern. LOCs give you the flexibility to instantly access cash right when you need it, for whatever your priorities might be – be it purchasing equipment, inventory or supplies; hiring staff for specific projects; or tiding you over during seasonal revenue fluctuations. You don't need to draw all the funds from your LOC, and you pay interest only on what you do. It's a feasible route, too – according to research firm Fed Small Business, business LOCs have a 73% approval rate.
Things to note
• It's not possible for every business. Any early-stage business can apply for a line of credit, but there are some minimum requirements. Broadly speaking, you'll need a personal credit score of above 560, and your business will need to be earning at least $50,000 in annual revenue and to have been operational for at least six months. Plenty of 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.
• Look beyond the bank. Going to a traditional bank is increasingly an option only for very established businesses with a serious track record. For early-stage businesses, there are plenty of alternative financing options online. But, be aware that these do tend to be more costly in terms of repayment – and penalty terms for failing to pay can be more severe than you might think. Some of these lenders run automated processes where you can simply input a few key details to find out if you're eligible.
• Secured LOCs are easier to get. Generally speaking, getting a secured LOC is preferable for a small business, because they tend to have a higher maximum credit limit and lower interest rates. Unsecured LOCs are also a lot harder to obtain – you have to show consistent revenue, be in a super-strong financial position and offer multiple sources of repayment.
How to secure a business line of credit
1. Clarify that you meet the bare minimum criteria. Before you get into the specific criteria of any lenders, confirm that you have the essentials in place: a strong personal credit score, enough revenue coming into the business and that you've been operating for at least six months.
2. Confirm that this is the right funding option. There are other forms of debt financing that might be more suitable for your needs. Remember, lines of credit are ideal for short-term working capital demands, like purchasing inventory during a busy season or offsetting seasonal dips in cash flow – for when you know that you'll need funds, but aren't sure exactly how much or when.
3. Decide on a ballpark for how much you'll need. This obviously isn't completely down to you, but it's helpful nonetheless to think about your business' needs and what kind of upper limit you'd ideally negotiate. You might bring in your financial controller or accountant at this point.
4. Get your info together. Most lenders will be looking to see some essential documents – think broad information on the business, your business plan, tax returns, bank statements and financial documents, like your cash-flow statements, profit and loss statements and balance sheets. Some lenders might also want to see forward-looking projections for balance sheets and cash-flow statements.
5. Get researching. Time to see what's out there. You could start by talking to your bank but, realistically, it makes sense to look online. Marketplaces like Lendio allow you to compare offers, but business banks such as Bluevine and Fundbox are also good places to start. You're looking to find out about maximum credit limits, repayment terms, minimum requirements and interest rates.
6. Submit your application. Whether online or in person, decide which lender best fits your needs and offers the most agreeable terms. At this point, you might need to supply more documentation. When it comes to your application, take the time to double-check everything. Ideally, find an external person to look over it to make sure everything is accurate and logical.
7. Find out about fees. Provided that you hear back from your lender, you need to find out about the associated fees. These can stack up very quickly. In particular, find out the opening or origination fee, the annual fee, maintenance fees, cash-advance fees and late-payment fees.
• Business lines of credit are a super-useful funding option for businesses with short-term working capital needs, like buying inventory, hiring staff or easing cyclical cash-flow problems.
• If you want to open a business line of credit, you'll need to meet the minimum requirements and get the appropriate documents together.
• For businesses without a substantial track record, alternative online lenders can be the way to go – though you need to watch out for high interest rates and hidden fees.
Tool. Lendio is arguably the best place to start when it comes to finding an online lender. It's essentially a lending marketplace – you apply with a brief application and it'll match you to the right lenders.
Example. So, what exactly do you need to show a lender to secure your line of credit? Finance marketplace Fundera breaks down the essentials.
Perspective. If you're torn between a business line of credit and a business credit card, check out this article from business resource site StartupNation that neatly sums up the differences.
A version of this article was published in the Courier Workshop newsletter. For more deep dives into essential business concepts, sign up here.