There are several key elements needed for a successful small business: a dedicated proprietor, a solid business plan, a service or products that address a need in the market, and, perhaps most importantly of all…funding.
Even if a business is successful from day one, proprietors may find it challenging to have enough cash on hand to pay for their everyday expenses and ensure that their business can continue to grow and expand.
This is especially true during periods of economic uncertainty, where sales may temporarily dip, but expenses like vendor bills, employee salaries, and leases remain the same. Managing cash flow becomes crucial in these situations to cover ongoing operational costs and address any gaps in funding.
The good news is that a business line of credit provides you with access to the cash you need to ensure your day-to-day operations can continue smoothly.
Read on to learn more about exactly how a business line of credit works, and other options for financing your small business such as a business loan and business credit cards.
What is a business line of credit? How is it different from a business loan?
A business line of credit describes funds provided by a bank or other financial institution that you can access in order to pay for business-related expenses, like purchasing and maintaining equipment, obtaining inventory, paying employees’ monthly salaries and rent for your physical storefront, and more. Similarly to a credit card, a business line of credit has a monthly limit, so you can charge up to a certain amount of money each period and then pay back those funds. The credit limit defines the maximum amount of money that can be borrowed, impacting borrowing capabilities and financial flexibility. A credit line is a flexible borrowing tool that allows businesses to access funds as needed, operating similarly to a revolving credit limit.
A business loan is a set amount of money that you borrow and receive in an upfront lump sum payment. Typically, a business loan will be a relatively large amount provided on a one-time basis and the funds will be deposited in your business checking account. The borrower is required to pay back the money during an agreed-upon period, with interest. Borrowers pay interest only on the amount they use, not the entire credit limit, highlighting the cost-effectiveness of this option.
The biggest difference between a business line of credit and a business loan is the revolving, fluid nature of the former. Unlike a business loan, a business line of credit gives a company the ability to borrow only the amount that it needs during each billing period – and that sum could change from month-to-month. With loan payments, borrowers typically need to pay a specific set amount each month or be penalized.
For example, if a business has a particularly successful sales period and wishes to make a payment bigger than the stipulated monthly repayment amount, the bank or credit union could charge them an additional fee for doing so. The reason for this is because lenders profit based on monthly interest rates, so they want borrowers to repay the loans within the agreed upon time-frame. If they pay off the loan quicker, the bank loses money.
Other major differences between business lines of credit and business loans include:
Collateral Nearly all business loans require borrowers to put up significant collateral, which could mean a business’ assets like its inventory, equipment, future sales, physical storefront and more, in exchange for the funds. Some business lines of credit are unsecured, meaning that borrowers can obtain them without needing to put up their assets. An unsecured line of credit does not involve collateral but typically requires a higher credit score and may feature lower credit limits along with higher interest rates.
Financing amount The amount of funding a business can obtain via a business loan is significantly more than what they can receive via a business line of credit. Because business loans are meant to cover a business’ expenses for the foreseeable future, the funds are larger. The amount of financing available to a borrower through a line of credit is usually meaningfully less than what can be obtained through a traditional business loan.
Business line of credit vs. a business credit card
A business credit card is a credit card that is specifically meant to cover business expenses. Typically, there are limits as to what a business owner can charge on their business credit card. Critical operating expenses such as payroll and leases for a storefront usually cannot be paid via a credit card, but a business line of credit can be used for them. It’s important to note that both business lines of credit and business credit cards require the borrower to have a solid credit history in order to be approved. For example, a minimum credit score of 680 is often required for bank business loans and lines of credit.
What do I need to be approved for a business line of credit?
To get approved for a business line of credit, you should have a good business credit score that indicates you responsibly pay your bills. Many banks, credit unions, and other financial institutions require that your business be in operation for at least six months prior to applying for the line of credit, and that you have a clear profitability model in place. Online lenders, on the other hand, offer quicker approval processes and often cater to startups and individuals with poor credit, although they may have higher interest rates and shorter loan terms.
How can I build up my business credit?
Ensuring that you pay your vendors and other bills on time is a crucial step to establishing and strengthening good business credit. It’s critical that you never miss a payment and avoid making payments later than when they are due. You should also check to make sure that your vendors are reporting your payments to business credit score reporting agencies, so that your fiscal responsibility can be appropriately reflected in a high score.
If I don’t have good credit, what are my options?
Don’t despair! There are a number of options offered by banks, credit unions, and other financial institutions which can provide you with funding, despite a shaky credit history. Even with a poor credit history, community development financial institutions (CDFIs) may still offer you funding. Some banks will be willing to provide you with a traditional business loan, albeit with higher collateral, which may include your personal assets. Small business loans are also an option, known for their flexibility and purpose, such as expansion, inventory purchases, or operational expenses. You can try a secured line of business credit, which sees you put up collateral in exchange for the line of credit. You may also consider a merchant cash advance, though that option is generally less preferable than a traditional business loan.
