Peter HuminskiFounder, Thorium Wealth ManagementView bio
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When it comes to business financing, entrepreneurs have many options. They can take out loans or use business credit cards, but for many, a business line of credit remains a favorite option.
Why You Might Need a Business Line of Credit
A line of credit works like a credit card or a home equity line of credit — you have a maximum amount that you can spend on anything your business needs. The business can spend part or all of the credit, but it cannot exceed it. Interest only accrues on funds that you spend from the line of credit. Business lines of credit are revolving, which means if you use the money and pay it back, you can use it again. But although a credit card cannot be used to pay for things like payroll and rent, a business of line of credit can. A business line of credit can be particularly effective at helping seasonal businesses survive a slump.
Read on to see how a business line of credit can help put your business on the map.
Most businesses —from a large retailer to a mom-and-pop store — can benefit from a business line of credit. It’s a tool that you can always have at your disposal but not draw on unless you need it. This way, you won’t pay unnecessary interest fees until circumstances call for it. A business line of credit can sustain you when cash flow is low. In addition to seasonal businesses, new businesses can benefit especially from a line of credit that can keep them going when times get tight.
The old adage “you have to spend money to make money” is true for businesses. In the beginning, you may need to run at a deficit until you acquire the necessary equipment, staff, and other basics to get your business started. If handled correctly, a business line of credit can be a relatively low-risk method of financing your business’ growth.
It’s important to remember that a business line of credit is not something to apply for when you’re already struggling. You should apply for a business line of credit when business is going well and you have a solid credit history. You’ll also have more time to shop around and find the best interest rates, credit limits, and terms.
How a Business Line of Credit Works
One of the best parts of a business line of credit is that it’s always available to you. If your line of credit is $55,000 and you make your payments on time, you have the ability to spend $55,000.
Line of Credit vs. Credit Card
A credit card works by allowing you to pay for resources and vendors by drawing upon the credit limit attached to the card.
A line of credit is like having someone loan you money straight into your bank account, which you can then use to pay for any kind of business expense.
A credit card has mandatory monthly payments, while a line of credit is more flexible: You have monthly payments only if you’ve tapped your credit line. (Of course, as with a credit card, interest will build up if you have an unpaid balance.)
A business credit card is great for earning rewards and cash back and having buyer protection in case you run into problems with what you purchased. But credit cards have higher interest rates than lines of credit and are not accepted as widely as bank transfers or checks. For example, the web developer you hire to create your business website might prefer to be paid via PayPal and not accept credit cards. That’s where a credit line comes in handy — you can use that cash to pay for your vendor. While you can get a cash advance on your credit card, it’s usually capped at 20 percent of your credit line and the interest is higher than that on a purchase.
Line of Credit vs. Business Loan
A line of credit has many benefits — the main being that it will not expire: As long as you make your payments and are in good standing with the lender, you may be able to renew your line of credit indefinitely. A business loan is like a mortgage or student loan — there is a fixed time for how long you have until you have to pay it back. If you don’t make regular payments, you’ll go into default and risk harming your credit score. You may even end up in collections or have to file bankruptcy if you fail to make payments. Loans usually have closing costs and higher interest rates associated with them.
A line of credit is something businesses can and often use continuously, like a credit card. A business loan is drawn up for a one-time purpose, whereas a line of credit is a resource that business owners have access to at all times.
A note of caution: Banks and other lenders generally offer a variable APR on business lines of credit, which means that the interest you pay on your line goes up or down depending on the market rates. If market rates shoot up, your interest rate will, too. This could be disastrous if you’re low on cash and you’ve borrowed tens or hundreds of thousands of dollars against your line of credit, so try not to let your debt build up. Secured vs Unsecured Lines of Credit
The difference between a secured and unsecured line of credit is that an unsecured line has no specific collateral behind it. For example, a mortgage is a secured line of credit, meaning that the bank can take your house if you fail to make payments. A credit card is an unsecured line of credit, meaning that the creditor would have to sue you in order to seize any assets.
Secured lines of credit are typically easier to get because the bank has more assurance that you are able to pay the money back. They also usually have lower interest rates because there is something backing the loan that the bank can use to collect its money immediately.
If you have an unsecured lines of credit, your creditor must first sue you and win in order to take your income or property. Usually, the lender will try to collect the debt for some months and then hire a collection agency to pursue you. If you have substantial assets, though, you may be sued — and creditors can attach your future income for up to 10 years.
LOCs: What to Watch Out for
Lines of credit have many benefits, but they also come with hidden costs and risks. Some may charge maintenance fees on a monthly basis and interest fees may add up quickly when you use the line of credit regularly. Most important, the variable APR can also soar if market rates increase.
How to Qualify for a Business Line of Credit
Qualifying for a business line of credit is similar to applying for a personal or business loan or a credit card. Lenders want to see that you’re someone who has a history of paying back your debts.
Here are some tips on how to qualify for a business line of credit from wealth management expert Peter Huminski.
Have a good credit score and pay all of your personal and business debts on time.
Make sure you have a plan for the line of credit that you can communicate to the lender.
When I worked as a lender that was one of the things that was always important in the credit decision. Lenders want to know why you need the money and what it is going to do to improve your business and increase the likelihood that you will repay the debt.
Don’t bite off more than you can chew.
Carrying tons of debt will cause lenders to pause and possible reject your request even if you have significant cash flow to cover the debt payments.
Have sufficient collateral.
Banks like to know that if you can’t repay them for some reason that they have a way to recover some or all of the money that they have lent out to you. Many small business owners use equity they have in their homes or office buildings or investment portfolios as collateral for their business lines of credit. This usually allows for the business owner to negotiate better terms and also the bank to be more comfortable with the risk over an unsecured business loan.
Have all of your financial information in good order. Have at least 3 years of business and personal tax returns and profit and loss statements and your corporate balance sheets available. Make sure you have a good accounting partner to help you prepare this information. Banks don’t expect you to be an expert in finance but they do expect you to hire someone to help you be organized with this information. That is why having a good CPA/accountant is very important.
Finally, have a passion for your business.
You are asking the bank to partner with you. You want to make sure you are able to communicate why they should lend you the money.
If You’re a Woman:
The Small Business Administration says that it has historically been harder for women to receive small business loans, even though they are the fastest-growing segment of the population starting businesses. According to some accounts, they are almost 20 percent less likely to receive a business loan. This is one reason why lines of credit may be a better option for women who have been denied a small business loan.
The Small Business Administration has a program for U.S. veterans that will help them get business loans. The SBA Express Loan program offers expedited answers to veterans, offers loans up to $350,000, and charges zero fees on those loans. Non-veterans can only get zero fees on loans up to $150,000.
Wealth management expert Peter Huminski weighs in below on how businesses can most effectively secure and use a line of credit.
What industries may benefit the most from having a business line of credit?
Pretty much all businesses and industries can benefit from having some sort of business line of credit. The most common uses for a business line of credit are for funding inventory purchases, marketing campaigns, or business expenses during seasonally slow periods of the business year. A business line of credit can provide you quick access to capital to help fund short-term needs.
Why would someone choose a business line of credit over a credit card or loan?
A business line of credit can be secured or unsecured much like a loan. The biggest differences are in payment terms, interest rates you would pay, [and continuous access to taking out and re-paying credit]. A business line of credit usually only requires interest payments monthly. A credit card is going to require a minimum payment of 2 percent of the outstanding balance. A business loan requires a payment of interest and some amount of principal based on the length of the loans term. Usually a business line of credit limit can be much higher than a credit card limit especially if the line is secured by suitable collateral. A business line of credit will also have a lower interest rate than a business loan and a credit card since they are supposed to be used for short-term financing needs.
Under what kind of circumstances should I consider getting a business line of credit?
If your business encounters occasional, and perhaps unpredictable, short-term capital needs, a line of credit could make sense for your business. For example, a seasonal business that does a majority of its sales in the summer could use a line of credit to fund business expenses during the slower periods of time. Another reason would be for purchasing inventory that will be sold quickly, and then the line could be paid off and the line could be used again to repeat the cycle.
What are the pros/cons of a line of credit?
The pros are that you can get a quick source of cash with semi-flexible repayment terms. They usually carry a significantly lower interest rate than a credit card and may have a significantly higher limit than a credit card. They will also help the business build its credit profile, which can be beneficial if the business may have lending needs in the future.
The cons are that there are upfront costs associated with putting a line of credit in place. There will usually be an origination fee of between .25 percent and 1 percent of the loan amount. There are also renewal fees annually, since most business lines of credit will require and annual review and renewal by the bank. Also, while it is great to have access to the cash when the business has a need, it is still putting a debt in place that needs to be repaid at some point. It is important to make sure that the business has sufficient cash flow to make the payments. Also, many times the business owner will have to sign a personal guarantee for the line of credit, thus making the owner liable for the debt even if the business fails.
What should I watch out for?
The devil is always in the details when it comes to loans. Make sure that you understand any and all covenants that may be present in the line of credit, especially if you are using inventory or accounts receivable as the collateral for your line of credit. Also many business lines of credit require that the line carry a zero balance for at least 30 consecutive days every 12 months.
Make sure you find a banking partner that understands what your business goals are for the next several years and is comfortable with them. If they aren’t comfortable with your plans, it may be best to shop around looking for a partner that can be there for you. Because it is a pain to have to change banks.
The New York Times’ small business center has a wealth of resources and well-researched articles about everything a small business owner needs to know, especially about borrowing money for their business.