When running a business, the adage “you have to spend money to make money” is smart to remember. Yet if your pool of savings is too shallow to cover an unexpected bill or purchase essential…
When running a business, the adage “you have to spend money to make money” is smart to remember. Yet if your pool of savings is too shallow to cover an unexpected bill or purchase essential inventory, the health of your enterprise is at stake. A 2018 survey conducted by The Firmament Group found 51 percent of business owners worry about access to capital at least once per week, and 41 percent say it has kept them up at night in the last month.
That’s where a business line of credit can come in. With it, you’ll have access to a financial institution’s deep reservoir of funds. As long as you use the line judiciously, it can be one of the best tools available to your business.
The Basics of a Business Line of Credit
With a business line of credit, a lender provides you with a fixed amount of money that you can use for such operating expenses as paying suppliers or meeting payroll. Some lines are unsecured, while others are secured with assets the lender can claim if you fail to pay as agreed.
You are free to extract what you need up to the preset limit, and the portion you borrow is considered a loan. Depending on the product, you will be expected to make payments in either weekly or monthly installments, with a payoff time frame of a few months to several years. After the loan is paid, the line reverts to the original limit. In most cases, the lender will review the line of credit annually to assess it for renewal.
A compelling benefit of business lines of credit is that interest is applied only on the borrowed sum. Therefore, if the line is $100,000 and you’ve withdrawn $20,000, the untapped portion of $80,000 won’t cost you a penny in financing fees.
That doesn’t mean the lines are free, of course. Business lines of credit come with a variety of other costs. There might be a fee to open the account, maintain it on an annual basis or to make each draw.
To tap into the funds, you may transfer what you need from the line to your checking or savings account by phone or online, or with a check or debit card provided by the lender. You may be able to extract cash from an ATM, but your lender might charge a fee of 2 to 3 percent of the advance.
How a Business Line of Credit Compares With Credit Cards and Loans
If you think these lines of credit sound like credit cards, you’re right. Both are revolving debt instruments, so the payments fluctuate based on the amount you owe. They’re also appropriate for short-term funding.
The key difference is that business lines of credit tend to have significantly higher limits than credit cards. Fundera, an online marketplace that connects business owners with funding providers, shows lines of credit are frequently in the $100,000 range and may even exceed $1 million.
Business lines of credit also have similarities with term loans, but there are distinctions. When you take out a loan, you’re borrowing all the money once. A loan’s repayment term is frequently five, 10 or even 20 years. While lines of credit are right for business expenditures that you will repay relatively quickly, a loan is the preferred product for things you need to finance over a long period.
Where to Get a Business Line of Credit
A number of financial institutions issue lines of credit. You may start your search with a large commercial bank, such as Wells Fargo, Bank of America or Capital One.
Local banks and credit unions are also excellent options, says Ebong Eka, president of Ericorp Consulting, a business consulting practice. These financial institutions exist specifically to serve the local community and tend to be more flexible when evaluating credit applications. “You can speak with the big boys about a line of credit, but the decisions will be done outside of where you are and by someone just looking at numbers,” says Eka. “You may have more success with a smaller bank or credit union.”
There are plenty of alternative lenders that operate online. Among them are Kabbage, OnDeck and LendingTree. Since the qualification process is algorithmic, approval is swift, says Ryan Conti, Fundera’s director of sales, though there are downsides to such immediacy. “It doesn’t have the same level of due diligence,” says Conti. “That risk is built into the cost of the loan, so the interest rates can be on the high side. It’s a trade-off.”
Still, some business owners are willing to accept the higher rate for instant access to necessary funds. Theo Lee, CEO and co-founder of the Los Angeles-based Korean food company KPOP Foods, started out with a line of credit from Kabbage. “We needed additional capital to hold us over during our equity crowdfunding campaign, so the total amount needed had to be over $15,000,” says Lee. “The interest rate was important, but not necessarily the most important thing.”
Another source of business lines of credit is the Small Business Administration, which partners with banks to offer the CAPLines program. These credit lines are granted for specific purposes, including building, seasonal expenses or contract needs.
Each lender sets its own qualification standards. Bank of America, for example, requires a business to be in operation for at least two years under the existing ownership and to have $250,000 or more in revenue. To obtain a line of credit at a credit union, you’d have to first become a member, usually by opening a deposit account, and then meet its unique requirements. For an alternative lender, the minimum requirements are typically that you’ve been in business for at least six months and have at least $50,000 in annual revenue.
Eligibility for the CAPLines program requires businesses to meet the 7(a) loan program standards and specific requirements for each type of CAPLines loan. The 7(a) eligibility requirements include size standards, operating for profit and reasonable investment of equity. CAPLines-specific requirements include demonstrating a pattern of seasonal activity or ability to complete construction projects.
To determine the size of the credit line, the majority of lenders depend on the five C’s of credit, says Christopher Ward, a small business lending executive for Bank of America. They are capacity (ability to repay), character (credit history), capital (earnings and savings), collateral (what can be put down as security) and conditions (the purpose of the loan plus the strength of the economy). Based on these considerations and your needs, the limit might be a few thousand dollars to $500,000.
As for the interest rate, lenders rely largely on personal and business credit scores. If your credit rating is low, the interest rates may be high, at least initially. If you treat the line responsibly, the lender might reassess the terms. For example, Lee’s first business line of credit was for approximately $20,000, with an interest rate of nearly 19.5 percent. After four months of making all payments on time, he refinanced the line. The limit rose to $35,000, and the interest rate fell to about 10 percent. “We saved thousands of dollars with a lower rate, which for us is significant, and also increased our liquidity,” says Lee.
What You Need to Apply
Most lenders require not only the basic details about your company — the type of business, legal structure and ownership — but also request earnings, financial statements and tax returns. If you’re interested in the CAPLines program, the SBA provides a thorough submissions checklist.
The lender will pull your credit reports to see how you’ve managed credit in the past and to understand your current debt load, so be prudent with applications. “You have to do your research before applying for anything because your personal credit will be taken into account,” says Eka.
If you try for a line with an alternative lender, you’ll typically learn the status of your application within minutes. Other lenders may take days or weeks to decide because they dig deeper into your financials.
Once you have the business line of credit, be careful to use the funds strategically. “Maybe you have a food truck and before the Fourth of July holiday you need a huge amount of inventory but don’t have the upfront money,” says Ward. “A line of credit would be great in this situation because you can borrow what you need right away. When you’ve made the money with that day’s sales, you pay it all back.”
There are plenty of other smart applications for a business line of credit, says Eka. Some examples include meeting payroll and unexpected expenses, paying out-of-season bills when cash flow is limited, buying products offered at a time-sensitive discount and purchasing equipment for operations, such as computers.
In fact, business expansion is one of the most common reasons business owners seek sources of capital, according to a 2018 survey conducted by TD Bank. To help fuel growth, they’re turning to credit products: 46 percent of those surveyed said they have or will apply for credit in the next 12 months, compared with 21 percent in 2017.
Before tapping into a credit line, whatever the purpose, “always run the numbers first,” says Eka. “Are you really sure you’re going to sell a thousand items before Christmas and then pay off what you took out from the line? If yes, do it. If not, don’t. You’ll get into trouble.”
The only time you should extract funds from a business line of credit is when you’re confident that you can handle the payments and will drive the debt to zero on a regular basis, says Eka.
This long-term approach to short-term capital sets the stage for positive opportunities in the future. “By making payments on time, you’re also building the company’s credit rating, which can allow you to refinance your line of credit at a lower interest rate and for a larger amount,” says Lee. Adopt this strategy and you’ll leverage the line, thus enabling you to make more money by spending more money.