For businesses looking to inject a small amount of capital to help sustain their operations, a loan seems excessive. You borrow a large amount and get locked into a lengthy payment schedule with a portion always going to interest expenses.
An alternative is lines of credit, a flexible borrowing option that gives you access to the money you need when you need it.
If you’re looking for an alternative to costly loans, then a line of credit may be the answer. But first, you need to understand how they work, what the options are, and what limitations you may face when using a line of credit.
What is a line of credit?
A line of credit is a form of revolving credit that borrowers can draw from as needed and only pay interest on the amount borrowed.
When approved for a line of credit, you’ll have a maximum amount that you can borrow. At any time, you can borrow up to that amount without going through the process of applying for a loan or other type of financing.
This makes lines of credit a flexible borrowing option for borrowers who want access to capital, but don’t want to be locked in to a long-term loan.
How does a line of credit work?
The two main components of a line of credit are the maximum credit amount and the interest rate.
The maximum credit amount is the most that you can borrow from the line of credit. If you need to borrow than the maximum credit amount, you need to apply for a new line of credit or reach out to your provider to have your line of credit adjusted.
The interest rate is how much you’ll pay on the amount that you borrowed. For example, if your interest rate is 10% and you borrow $1,000, you’ll pay $100.
Interest accrues every month the amount borrowed hasn’t been paid back. For the $1,000 borrowed, every month incurs a $100 interest cost.
Interest rates may be fixed or variable. A variable interest rate will change based on an index while a fixed interest rate is set for the lifetime of the line of credit.
While lines of credit don’t have a set payment schedule like a loan, they typically have a minimum payment amount that must be paid every month. It’s also possible to pay down the entire debt as quickly as you want to minimize any interest costs.
Depending on the type of line of credit you’ve been approved for, you can continue to draw from the line of credit until the total outstanding amount hits the maximum.
Types of lines of credit
Lines of credit vary depending on who is borrowing, how the line of credit is structured, and whether collateral is required.
Let’s break down some of the common varieties offered by lenders.
Personal line of credit
Personal lines of credit are distributed to and maintained by individuals. The line of credit is under their name and any collateral provided must be personal assets.
On-time and consistent payments will improve the individual’s credit score. But a lack of payments will hurt the personal credit score and could impact the ability to get personal financing down the line.
To apply for a personal line of credit, you need to provide identification, proof of income, and consent to a credit check. Note that a credit check may impact your credit score.
In some cases, a personal line of credit can be used to finance a business. In particular, sole proprietorships treat both the individual and the business as the same entity meaning the line of credit can be used seamlessly for business and professional purposes.
This allows some businesses to explore the option of using a personal line of credit for funding in the early stages of their operations before having an established financial presence and credit score.
However, the process gets complicated if the business is a partnership or has been incorporated. It’s recommended you talk with an accountant before mixing personal and business financing.
Business line of credit
Business lines of credit are distributed to and maintained by businesses. It’s the business that is liable for the debt with the business’s assets being used as collateral.
By having the line of credit in the business’s name, the owners and shareholders have some—but not complete—protection if the business defaults on the debt.
Any activity impacts the business’s credit score.
Applying for a business line of credit requires financial statements, legal documents, consenting to a credit check, and past tax returns. You may also be required to submit a business plan or an outline of how the line of credit is to be used.
For seamless access to the line of credit and to protect owners and shareholders, it’s recommended that businesses explore business line of credit options before considering using a personal line of credit to fund business activity.
Secured vs unsecured
A secured line of credit is when a lender requires an asset, such as a piece of property or cash, to serve as collateral to approve the loan. In some instances, if you were unable to pay back the loan within the agreed upon timeline, the lender could take the asset to make up for the difference.
Secured lines of credit are favored by borrowers that haven’t established solid business credit yet. Providing collateral gives lenders the confidence to offer higher credit amounts at lower interest rates, especially in the case of early stage businesses.
An unsecured line of credit does not require any collateral. Typically, unsecured lines of credit have lower maximum credit amounts and higher interest rates.
The biggest factors you should consider when choosing between a secured or unsecured line of credit are your risk tolerance, desired credit amount, and ability to make regular payments.
Revolving vs non-revolving
A revolving line of credit can be used over and over; once you pay off your debt, the line of credit is available for you to use again. You will usually have to make minimum monthly payments, and an interest rate will be applied to the amount you borrowed.
On the other hand, you cannot use a non-revolving line of credit after you pay it off. You are approved for a maximum amount and can take as much or as little as you want, but you cannot continue to draw from the line of credit. If you need more financing you would have to go through the approval process again and take out another loan or line of credit.
Non-revolving lines of credit often have lower interest rates, and you can usually get approved for a higher amount of money than you would for a revolving line.
Limitations to lines of credit
While flexible, a line of credit isn’t the solution for everyone. Keep in mind some of these limitations when weighing out different types of borrowing.
High interest rates
Compared to other types of financing (like loans), lines of credit have higher interest rates.
Then there’s the added complication of variable or fixed rate lines of credit. A fixed rate line of credit locks you into an interest rate while variable rate means the interest rate changes based on an index.
Variable rate lines of credit open you up to the risk of your rate jumping up making the cost of borrowing more expensive. When costs jump, you’re less likely to use the line of credit you worked so hard to obtain.
Additional fees
A line of credit often comes with fees to open and maintain an account, even if you aren’t actively borrowing from it.
You may incur account fees, withdraw fees, and origination fees over the lifetime of the account.
If you were thinking of holding onto a line of credit in case of emergency, it may still cost you to keep it despite being inactive. Compare the different line of credit options available to you and try to find one with a fee structure that will keep your costs low based on how you intend to use it.
Low borrowing amounts
Lines of credit will have a lower borrowing amount than a traditional loan.
Depending on how you intend to use it, this may not be a problem. But generally speaking, the more you’re looking to borrow, the less suitable a line of credit is to get the job done.
Potential overborrowing
The financial health of a business is constantly changing. While the degrees of difference may be small, they could impact your ability to pay down debts.
For example, a business might apply for a line of credit during a period of strong financial performance. Then, after many months pass, their sales slow down, cutting down their profits and hurting their cash flow.
If they turn to their line of credit, they have access to a large amount of capital that comes with high costs. These costs could turn the situation from bad to worse.
Borrowing from a line of credit during a time of need is what they’re there for. But you still need to plan and budget for the costs that come with it.
Not suitable for large purchases
Since borrowing amounts are low and interest rates are high, lines of credit aren’t suitable for funding large purchases like new equipment, vehicles, or real estate.
Instead, it’s worthwhile to shop around for other funding options like traditional loans that have a set payment structure, comparatively lower interest rates, and access to higher borrowing amounts.
Access the funding you need with the BILL Divvy Card
Issued by Cross River Bank, Member FDIC, the BILL Divvy Card powered by Visa offers credit lines from $1000–5M.* Your card also comes with BILL Spend & Expense software, giving you more control over budgets and a more efficient way to track business expenses.
Empower your team to make secure purchases by leveraging physical cards or generating virtual cards. Either way, you’ll have powerful tools to run your business with greater confidence.
Schedule a BILL Spend & Expense demo for a personalized consultation and see how it works.
*Credit lines and the advertised range are not guaranteed and will be determined upon application approval.
Line of credit FAQ
How to qualify for a line of credit?
Borrowers will qualify for a line of credit based on their:
- Credit score and prior credit history
- Financial history (as reported on financial statements or transaction history)
- Duration of existence
- Collateral
- Prior history with the lender
The above is a general framework used by lenders to evaluate whether a borrower qualifies for a line of credit. Lenders may require extra information or have additional eligibility require for the lines of credit they offer.
When a line of credit is useful
Lines of credit are useful for managing the ups and downs of cash flow. They can help you cover expenses when cash reserves are low or mitigate the effects of seasonal sale trends.
Line of credit vs traditional loans
A loan gives you a set amount in funding upfront that is paid off periodically according to a payment schedule. Interest is charged on the full amount and there are typically prepayment fees that prevent you from paying down the debt early.
A line of credit offers more flexibility. You borrow as much or as little of the maximum credit amount as needed and only pay interest on the amount you use.
There’s no set payment schedule for a line of credit. While there may be a minimum monthly payment, you can pay down the debt right away or take your time (just be mindful of the interest costs).
But the flexibility comes at the cost of lower borrowing amounts and higher interest rates.
Line of credit vs credit cards
Credit cards come with a maximum credit amount. You can charge expenses to the credit account up until the credit limit.
Payments must be paid monthly and if you’re on time with your payments, you’ll incur no interest costs. However, you may have monthly or annual account fees to keep the credit card active.
Lines of credit have a similar structure with two key differences.
First, you pull funds from a line of credit as opposed to charging expenses directly to the account.
Second, you will be charged interest at the point of withdraw. This means that you can’t borrow from a line of credit without paying some amount in interest expenses.
Line of credit vs merchant cash advance
Some payment processors offer merchant cash advances which are essentially a loan that is paid down by taking a percentage of your sales revenue. The amounts you have access to are generally low and come with high costs.
But because payments are taken from your sales revenue, you don’t need to worry about making monthly payments. You’ll be charged the interest up front and the full amount of the principal and interest is whittled down with the amount taken from your revenue.
As a result, merchant cash advances are a lot more structured than a line of credit. You don’t have the luxury of choosing how much you borrow and when, but at least you’ll know your costs up front.
Line of credit vs invoice factoring
Invoice factoring services will give you money upfront for uncollected invoices. They then begin the collections process to get the payment from the delinquent customer.
In some cases, the invoice factoring company will pay you a flat amount and then begin the collections process and keep the whole payment. Alternatively, they would pay you a portion upfront and then pay the rest when the collection is complete. But in both situations, they keep a portion of the invoice for themselves as payment.
Unlike a line of credit, there are no payments that need to be made. But you only have access to invoice factoring if you have unpaid invoices in the first place. The maximum amount you can finance depends on how much you have in outstanding accounts receivable and how much the factoring company is willing to give you for them.
Does line of credit hurt credit score?
A line of credit may hurt your credit score. More specifically, borrowing a large percentage of your credit amount or making late payments will hurt your credit score.
However, if you make timely payments and keep utilization low, you’ll improve your credit score.
To minimize any impact on your credit score, try to use no more than 30% of the maximum credit amount and be timely with your monthly payments.
*The BILL Divvy Card is issued by Cross River Bank, member FDIC, and is not a deposit product.
