Have you ever gotten a sudden windfall of cash and it felt like you won the lottery? In a way, a line of credit feels the same way. As a small business owner, the cha-ching sound you hear in your head comforts you every time you withdraw cash from the line. It means money is on call, day or night, at your disposal, providing a cushion to pay expenses. In a nutshell, when you use a line of credit for business needs, you have access to funds on demand. Is it really as good as it sounds? Learn here the pros and cons of using a line of credit.
How a Line of Credit Works
A lender agrees to offer you a loan in a predetermined amount you can draw on in increments up to the maximum amount of the credit line. Instead of paying interest on the lump sum, you only pay interest on what you actually borrow.
Most banks and credit unions offer lines of credit (also called LOCs) to customers. Here’s some helpful information about this funding option along with pros and cons for usage.
- Amounts: Loan amounts are based on risk and therefore vary among lenders and borrowing guidelines. Some lines max out at $15,000-$30,000+ while some are in the six-figure range for clients that have savings accounts at the financial institution where they apply for funds.
- Interest rates: Expect to see a wide range of variable rates (the interest rate can go up or down) among lenders. Rates may be based on the type of loan, the borrower’s credit standing, and the current prime rate. The prime rate is the lowest rate at which money can be borrowed from commercial banks by non-banks. One thing’s for sure: a variable rate doesn’t stay the same. That means the interest lenders charge could fluctuate in either direction—for example anywhere between 7%-25%.
- Interest is only charged on money you’ve withdrawn from the line of credit (as opposed to loans where you receive a lump sum and start paying interest the first day).
- The interest you pay is normally tax deductible.
- It’s considered a revolving account because as long as you repay the money, you can borrow from the line again.
- It’s advantageous to anyone who keeps a close eye on the budget and cash flow and is a good money manager.
- Interest rates tend to be higher than other funding alternatives so a line of credit is better used for short-term cash needs instead of long-term investments.
- Having access to a pool of money can be tempting. Entrepreneurs that are already controlled spenders are more successful at allocating funds without succumbing to overspending.
- Most banks will charge annual (or even monthly) fees for having a line of credit open.
A Line of Credit Offers Borrowers Flexibility
With a line of credit, the money is yours to use, at will, as long as you pay off what you borrow on time and in full. This flexible arrangement puts you in charge of your finances –if you keep it under control. You choose when to make credit withdrawals and repay advances. As long as you stick to the agreed-upon terms, you can continue to borrow money.
Moreover, you can use the cash as desired. Business owners can cover payroll expenses, buy supplies, or use line withdrawals to boost cash flow. Should business equipment or one of your service trucks break down, you have cash on hand to pay for unexpected repairs. Businesses that are cyclical in nature can use a line of credit during slower, off-season periods.
Lenders may or may not require collateral such as cash, inventory, accounts receivable, and other assets. If you have a higher credit score, you will most likely qualify for an unsecured line, that is, with no collateral required. That’s because in the eyes of a lender you’re more creditworthy. Just so you know, some lenders charge annual maintenance fees or may impose late fees and penalties for exceeding credit limits.
A line of credit is a helpful financial tool when used correctly. However, if you routinely keep a high credit line balance, this normally lowers your credit score, the same way it would happen with a credit card. The reason has to do with credit utilization. Credit reporting agencies notice how much credit you use in relation to how much credit is available.
Types of Business Lines of Credit
- Asset-based Line of Credit: Lenders use a business’s assets normally listed on the company’s balance sheet as collateral. In addition to inventory and accounts receivable already mentioned, equipment, buildings, patents, and vehicles are assets also used to secure a line of credit. Interest rates on asset-based lines of credit are usually lower. If the loan is not repaid, the banks can seize the property and sell it. Typically, you can get an ALOC from a bank such as Wells Fargo or specialty commercial lenders such as CIT.
- Unsecured Line of Credit: In this case, you don’t use your fixed assets to pledge as collateral. That means the lender assumes more risk when you borrow the money, so expect to pay higher interest rates and to get a smaller loan. The most affordable way to get an unsecured line of credit is through your existing bank. Typically, they’ll send you a notification when you automatically qualify for one of their LOCs. Alternatively, there are non-bank financial institutions that offer these products such as American Express and Kabbage.
Differences between a Line of Credit and Other Types of Financing
LOC Business Term Loan
|Make withdrawals as needed |
Renewed every 1-2 years
Only pay interest on borrowed money
Charges annual fees
Money normally used for short-term investments
|Receive money all at once |
You pay back the loan within a specified time
Pay interest on the entire loan amount
No annual fees
Terms loans are ideal for long-term investments
|LOCs cost less to use |
Approval from banks may take months
Getting access to money is easy
Available credit is reduced every time you make a withdrawal
|You sell invoices at a fee. If your profit margin is high, factoring is a good option |
Takes about 2 weeks to set up factoring
You don’t need good personal credit to get approved
LOC Credit Cards
|Secured and unsecured |
Flexible payment plans
Used for business expenses
LOC limits can go up to the millions
|Normally unsecured |
Receive credit, not cash
Requires minimal payments every month
Used for everyday expenses
Credit card limits typically cap at $100,000
When Is a Line of Credit a Good Idea?
If you already pay your bills on time, you know how to stay on top of cash flow. What happens when unforeseen expenses come up like paying additional staff or contractors? Do you have enough money to pay those types of expenses without causing a shortfall in your finances?
To compensate for clients that pay late or a market downturn, a LOC gets you through rough patches. As outlined above, you only pay interest on money you’ve withdrawn. You can repay withdrawals at any time without paying a penalty. If you designate a credit line for emergencies, it’s less likely you’ll abuse the privilege of having secondary funds to draw from. The bottom line: don’t use a LOC for long-term investments and repay the line often to keep the interest rate low and your credit score high.
When Does a Camino Financial Loan Make More Sense?
When you need cash to purchase equipment and other fixed assets, term loans help you grow your business to increase your sales and profits. Businesses just starting out that don’t have enough cash flow and want to expand their businesses are also good candidates for term loans.
At Camino Financial we offer business term loans in amounts that range from $5,000 to $400,000, so they adapt to any of your business needs. These are some of the benefits you’ll get by choosing us as your financing option:
- Our requirements are more flexible than most lenders: mainly, we take into consideration your personal credit and global cash flows of your business.
- Funds from our loans can be used for any business purpose: hiring employees, buy more computers or office equipment, or have more money to lease a larger space, among others. You can also use the funds to pay off personal loans or credit cards that had been utilized for business purposes. You can even use the loan to purchase a second business.
- In order to apply for a loan with Camino you should generate sales of $30,000 annually or $2,500 a month, a much lower amount than those required by other lenders
- While it’s recommendable that your company has been operating for at least 2 years, we take into consideration businesses with just 9 months in operations.
- Camino Financial is open to financing borrowers with no credit history.
- You don’t have to provide us with collateral.
- Since our interest rates average from 1% to 2.5%, term loans are an affordable borrowing option.
- Once you’ve had a business loan for 8 months and made timely payments, you can graduate to a new loan with better terms and interest rates.
By using our business loan calculator, you’ll see at a glance what loan amount, monthly payment, and interest rate fit within your budget. Then all that’s left to do is fill out this simple loan application online: you don’t commit to anything and it will immediately let you know if you qualify for a small business loan. Then, one of our loan specialists will contact you to guide you through the rest of the process. You could have funds in your hands in 4-10 business days.
Really, the loan process is that easy and straightforward. Why not take a step forward and let us help you explore funding options that match your business needs!