According to a recent report by Fed Small Business, business lines of credit have become increasingly popular among small businesses. In fact, 43 percent of small businesses sought a business line of credit in 2022, while only 34 percent opted for a traditional business loan.
A business line of credit is a flexible form of financing that operates similarly to a credit card. It allows you to withdraw funds as needed to cover unexpected expenses, manage cash flow gaps, or keep your business running smoothly. You only pay interest on the amount you use, and you can re-use the funds as you pay down the balance.
There are two types of business lines of credit: secured and unsecured. A secured line of credit requires collateral, but it often comes with better interest rates and loan terms. Before applying for a business line of credit, it’s important to consider the pros and cons.
Business Line of Credit Pros
Business lines of credit offer several key advantages that make them worth considering.
Improved Cash Flow
Cash flow issues are common in businesses, especially due to past-due invoices or seasonal downturns. Having a business line of credit provides you with a pool of funds to tap into whenever you face these situations. It ensures that you can continue operations and avoid shutting down your business.
If you’ve been denied a traditional bank loan due to factors like your credit rating or time in business, a business line of credit may still be a viable option. Some lenders have more lenient eligibility requirements, making it possible to secure a line of credit even with bad credit or as a startup.
For instance, Credibly business loans offer lines of credit of up to $300,000 to small business owners with credit scores as low as 600 and just six months in business.
Building a Relationship with the Lender
A business line of credit provides an opportunity to establish a relationship with the lender. Managing credit responsibly and paying back the funds can lead to credit line increases, easier renewal processes, and better terms in the future. Opening a business checking account with the lender can also help build trust and showcase your cash flow.
Potential for Building Business Credit
If the lender reports account activity to business credit bureaus, a business line of credit can help you build business credit. As your business credit score improves, you gain access to more funding opportunities and better financing terms.
Business Line of Credit Cons
Despite their flexibility, business lines of credit also have some drawbacks.
Business lines of credit may come with various fees that borrowers need to be aware of. These fees can include an origination fee, monthly maintenance fee, annual fee, draw fee, wire transfer fee, payment processing fee, late fee, and early repayment penalty. It’s important to carefully consider these costs when evaluating the affordability of a business line of credit.
Interest rates on business lines of credit tend to be higher compared to traditional business loans. While competitive rates are available to borrowers with solid credit ratings and who meet eligibility requirements, online lenders often charge higher rates compared to traditional banks and credit unions. On average, business lines of credit have APRs ranging from 8 percent to 60 percent or higher.
Short Repayment Terms
Many business lines of credit have a draw period during which you can access funds. However, once the draw period ends, the amount you owe is converted into a loan with a set repayment period. The loan term can be brief, depending on the lender, essentially turning your line of credit into a short-term loan. Online lenders typically have shorter repayment periods, ranging from 12 weeks to 24 months.
Limited Impact on Credit
Some online lenders do not report business line of credit activity to credit bureaus. As a result, making timely payments on your business line may not have a significant impact on your personal or business credit rating.
Alternatives to a Business Line of Credit
If a business line of credit isn’t the right fit for your company, there are alternative funding options to consider.
Business term loans offered by banks and online lenders provide a lump sum of funds that can be repaid in equal monthly installments over time. These loans typically come with repayment periods of five or more years. However, strict eligibility criteria and lower rates may make it difficult for some businesses to qualify.
Invoice factoring involves selling unpaid invoices for cash. Factoring companies offer a percentage of the invoice value upfront and handle the collection process. This option provides fast cash, but it often comes with higher fees based on the time it takes customers to pay their invoices.
With invoice financing, you can get an advance of up to 85 percent of your accounts receivable. Once you receive payment, you repay the amount advanced along with any associated fees. Similar to factoring, invoice financing may also have high rates and fees.
Merchant Cash Advances
Merchant cash advances (MCAs) are accessible funding options, especially for businesses with bad credit. Instead of evaluating credit scores and financial history, lenders assess credit card sales to determine eligibility. Approved borrowers receive a lump sum payable based on a percentage of daily credit card sales. However, MCAs often come with steep fees and high APRs.
Crowdfunding allows you to raise funds for your business by offering a percentage of equity or other incentives to investors. It avoids the traditional financing process and can provide exposure for your business. However, it requires significant time commitment and carries the risk of idea theft. Crowdfunding platforms also charge fees, and failing to meet fundraising goals may require returning donations.
Business Credit Cards
Business credit cards can serve as a funding source for your company. They typically come with generous spending limits, sign-up bonuses, and interest-free introductory periods. Business credit cards also offer perks, such as employee cards and business-related discounts. However, they lack some consumer protections and can lead to significant debt if minimum payments are made for an extended period.
Business lines of credit have numerous benefits, making them attractive to both new and established companies. However, it’s important to consider the potential drawbacks and explore alternative funding options based on your company’s financial status and unique needs.
Frequently Asked Questions
- When is a business line of credit a good idea?
- Is it hard to get a business line of credit?
- What credit score do you need for a business line of credit?
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