According to a report by the Federal Reserve, 37% of businesses applied for loans, lines of credit, or merchant cash advances in 2023. The reasoning is simple: capital is an invaluable resource when establishing and growing a business.
But even if you determine you need to borrow money to accomplish your goals, you need to know your options to pick the one that’s the best fit for your unique needs.
One option to consider is a line of credit: a flexible and versatile source of credit that gives you access to money when you need it. Read on to learn if it’s right for you.
What is a business line of credit?
A business line of credit is a flexible type of financing that gives your business access to a set amount of funds which can be pulled from as needed. Interest is only paid on the amount that you use.
For example, if a business is granted a $50,000 line of credit, they can draw up to that amount at any time, or otherwise draw money as needed. If they withdraw $10,000 to cover expenses, they only pay interest on the $10,000.
If you don’t have any funds withdrawn from a line of credit, no interest is charged. However, there may be monthly fees that are charged to keep the line of credit active.
Business line of credit vs business loan
The main difference between a line of credit and a business loan is how the money is distributed.
A business loan is distributed all at once. If you get a business loan for $10,000, the full amount is paid out at once and interest is charged on the outstanding amount.
A business line of credit is distributed as you wish. You decide how much you withdraw and when.
The business loan has a set timeline that the amount is paid off over and once the balance is paid off, the loan is complete. With a line of credit, the account remains open so you can continue to draw funds from it as needed.
What do businesses use a line of credit for?
When considering if a line of credit is right for you, you should have an idea in mind of how it’ll be used. Here are some common ways businesses use their line of credit to help support their operations.
Managing cash flow
Every business will have its ups and downs. That’s why it’s essential to have something you can rely on to help weather the low points or sustain the momentum of high traffic.
Having a line of credit accomplishes exactly that. It’s a resource you can turn to if cash flow is tight and keep operations running smoothly without disruption.
This is especially helpful for seasonal businesses that make a large amount of their revenue in a short period of time, like outdoor retailers that have a summer rush.
Purchasing inventory during high-demand
Just as a line of credit gives you flexibility to cover costs when sales activity is low, it helps you capture demand when activity is high.
Making sales is great, but you need the inventory to fulfill those sales. For businesses, this is a common catch-22: you need money for inventory, but you don’t have inventory to sell to make money.
Gardyn uses its line of credit to break this cycle and cover both inventory and advertising costs to capture and sustain demand.
A line of credit helps you buy as much inventory as you need when you need it. Then, as the sales start rolling in, you pay down the balance and only pay interest on what’s necessary.
This is especially true if you’re placing large inventory orders to take advantage of bulk discounts. You get to keep your per-unit pricing low and keep sales flowing.
Investing in growth
Beyond inventory, the next tier of performance might be unlocked behind an upgrade to your equipment, software, or other capital cost that’s difficult to cover on your everyday cash flow.
For these large purchases, a line of credit saves you from having to go through financing or find funding to make the purchase.
Having a line of credit to turn to helps you be less reactionary. Rather than jump for the first option that helps you make the purchase, you make the purchase when you’re ready knowing that you have the funds to draw from and at what cost.
Covering unexpected costs
You might have the perfect financial plan that’s dialed to the last cent. But what happens if something unexpected gets you off course?
Maybe a delivery vehicle breaks down or you need more headcount than you initially planned for. No matter what the reasoning is, you have a backup plan to cover the costs in the interim.
The quick access to funding is crucial for keeping operations running and avoiding any hiccups. That peace of mind you get from a line of credit is invaluable.
The benefits of a line of credit
A line of credit offers some unique perks compared to other borrowing options. You might opt for a line of credit because of some of the following benefits.
Cost controlled
With a line of credit, you take what you need and you only pay for what you take. Whether it’s $1,000 or $100,000, the interest you pay reflects how much money you borrowed.
Because of this, you can keep the costs of borrowing lower than if you were to take out a loan with a larger balance than what’s necessary.
You can also pay down a line of credit balance as quickly as you want. While loans often have prepayment penalties if you try to pay down the amount early, you could pay down the line of credit balance as soon as you have the funds available to minimize the interest you pay.
Flexibility
After getting approved for a line of credit, it’s up to you to determine how and when you use it. You could just as easily take the full amount on day one as you could hold off and keep the full amount for when you need it.
This choose-your-own-adventure style of financing gives you the ultimate flexibility to decide what amount of debt you’re willing to take on given the current state of operations. As your business grows and your financing needs increase, you might choose to get more liberal with the amounts you pull.
Repayment terms can be just as flexible with no schedule of regular payments. Many providers let you pay down the balance as you choose (although the interest amount must be paid every month).
Be mindful of the fact that interest accrues on the outstanding balance every month. While you can take as long as you need to pay down the balance, the costs will keep adding up.
Quick access
Applying for a small business loan is no small feat. It often requires digging through past financial reporting, compiling crucial information, and filling out applications only to wait and see if you’ll be approved.
Then once you’re approved, you need to wait for the funds to be deposited into your bank account. The work put into a loan application and the processing times both get in the way of you being able to put that money to work.
With a line of credit, once you’re approved you can access the funds quickly and easily. No more waiting with bated breath to see if you’re being approved; instead, you have funds in your bank account as soon as the same day.
The challenges of a line of credit
Lines of credit aren’t the best borrowing option. There are potential pitfalls to be mindful of and try to avoid if your application is approved.
High interest rates
The convenience of lines of credit comes with some extra costs, mainly high interest rates.
The reason for high-interest costs is that the financial institution can’t guarantee when the money will be withdrawn and when it will be paid back. Compare that to loans which have strict payment schedules that outline how much will be paid back by what dates.
To counter this uncertainty and risk on their behalf, they make the costs higher in the form of interest rates and potential account fees.
As a general rule of thumb, borrowing large amounts should be done with loans or structured financing which is more rigid, but keeps costs down as a result.
Potential overborrowing
The convenience and accessibility of a line of credit can be a double-edged sword. Turning to a line of credit too frequently creates a dependency on financing that will continually hurt your bottom line.
If you’re not careful, the interest costs based on what you borrowed can eat into your margins and hurt your ability to pay down the balance. Then you’re going back to the line of credit for more funds and the cycle continues.
It’s important to set expectations for the line of credit. Even if you’re granted a higher maximum amount, maybe you set your own acceptable amount to borrow that’s less.
To feel secure in how you’re using the line of credit, consider writing out a line of credit policy that outlines:
- How much can be withdrawn at any point in time
- What allowable expenses can be covered with the line of credit
- The maximum interest amount the business is willing to pay in a month
Possible renegotiation of terms
Lines of credit often have variable interest rates that reflect any changes in interest rates at large.
Lenders will review the terms of your line of credit sometime after it has been active. If they determine it’s no longer in line with the market, they could change it.
All of a sudden the line of credit you accepted at a reasonable rate unexpectedly balloons or the fees increase. The cost of borrowing may become untenable for you making the line of credit unusable.
If you want to keep costs consistent, consider loans that lock in an interest rate and payment terms at the start of the process.
Line of credit best practices
If you’re approved for a line of credit, make sure you’re following these best practices to keep usage and costs in check.
Draft a line of credit policy
A line of credit is a valuable resource, but should only be used when necessary. To keep usage in line with expectations, draft up a policy for usage of the line of credit.
Your line of credit policy should:
- State the purpose of the line of credit
- Appoint a point person who authorizes usage
- Define permissible uses
- Set maximum allowable withdrawal amounts
- Outline the reporting responsibilities and approval process
Keep this policy in an easily accessible place so everyone can refer to it as needed.
Set your payment schedule
The flexible repayment terms are a definite perk of lines of credit. However, some businesses benefit from a structure that they can plan around.
If this sounds familiar, take the initiative by drafting a payment schedule the business needs to adhere to.
You can still take advantage of the flexible repayment terms with your own drafted payment schedule. For example, if you have a $5,000 outstanding balance and you have an upcoming sale, you could plan to pay down the bulk of the amount after raking in that increased sales revenue with the remainder paid off before or after.
The schedule will only be for internal use meaning it’s adjustable if cash flow is better or worse than expected. But that initial structure helps you stay accountable for paying down the balance.
Shop around for alternatives
Once you have a line of credit, you can continue using it as needed. But as time goes on and your business continues to grow, better options might pop up.
This is especially true if you’re diligently maintaining your line of credit. Making regular payments and paying down balances to zero when possible can increase your credit score, opening up options that were previously unavailable to you.
Once every few months, it’s worthwhile to shop around and see what competitors are offering. You could find yourself saving big with lower interest rates and account fees.
It’s best practice to close any lines of credit you won’t continue to use, but be mindful that closing an account could potentially hurt your credit score. If you’re switching to an alternative line of credit, do so before you close your current account.
How to get a business line of credit
Getting a business line of credit requires some footwork before you start applying. Follow our step-by-step guide to get a line of credit that works for you:
- Determine usage and needs: Consider how the line of credit will be used and with what frequency you will borrow from it. This will help you determine what cost structure works best for you.
- Compare lenders and offerings: Start to compile your options across banks, credit unions, and online lenders. Document their interest rates, payment terms, and maximum amounts.
- Compile documents: Different providers will have different requirements, but generally speaking you should prepare financial statements (income statements, balance sheet, and cash flow statements), legal documents, bank statements, and a plan for the line of credit.
- Submit an application: With the provider selected and documents prepared, submit your application.
- Review the terms of the agreement: If approved, you’ll be given a credit limit, interest rate, account fee structure, and terms for review. Make sure these are in line with your expectations before accepting.
- Sign the agreement: Agree to the terms and confirm that you’ll take the line of credit as outlined.
- Put the funds to use: The funds become accessible and can start being used in your business as needed.
Access credit and improve spend management
Access to credit is just one piece of your overall financial puzzle. But what if you could get access to credit and increase your understanding of your finances?
With BILL, you can streamline accounts payable, invoicing, forecasting, expense management, and more, all while getting access to credit lines ranging from $500 to $5 million.
Reach out to learn more about what options are available to you.
