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Understanding Small Business Lines of Credit

A line of credit can give your business the flexibility to get cash whenever you need it to meet your ever-changing business goals. We'll explore how they work and how they differ from other business loans.



Table of Contents


How do lines of credit work?


OK, let’s start with the basics. What is a line of credit? Lines of credit are arrangements between lenders and borrowers that provide a maximum loan amount the borrower can use when they need it. With a line of credit, rather than take the maximum amount you qualify for up front, you can access funds over time, at any time, as long as you don't exceed the maximum amount.

The biggest benefit of a line of credit is its flexibility. You don't ever have to use the total amount you're approved for if you don’t want to. Plus, you only pay back what you’ve used, and you only pay interest on what you borrow.

You may hear different words used with lines of credit, such as secured, unsecured, revolving and non-revolving lines of credit. Most lines of credit offer revolving credit, meaning you're able to continuously borrow money until you've reached your credit limit.

In some ways, a revolving line of credit is like a credit card. With a credit card, whenever you make a purchase, that amount uses up some of your total credit limit. And when you make a payment, that amount frees up that amount of your credit limit. More details on revolving lines of credit in a moment.


How do I get a business line of credit?


Most traditional banks offer lines of credit for businesses. These will often provide the lowest interest rates possible. However, these can take weeks to obtain and are typically the most difficult lines of credit to get approved for. They usually require good personal and business credit, a solid established business history and lots of documentation.

Many online lenders (some banks and some not banks) offer lines of credit to small businesses with less established credit histories and less predictable, long-term results. These lenders typically require far less documentation and paperwork than traditional banks.

Online lenders offering lines of credit use online applications and automated approval systems to make decisions very quickly. In some cases, these lenders can approve lines of credit in a matter of minutes or hours, instead of days or weeks.

If you are approved for a line of credit but don’t need the funds yet, that’s ok. You don’t have to start paying anything back until you actually withdraw some of the funds. And if you want to use some of the funds but not all of them, you’ll only pay interest on what you use.


What is revolving credit?


Many businesses use a line of credit to increase their working capital from time to time. Using small business financing of this type is a great way to help you meet your business needs when, from time to time, your cash flow might not be sufficient to do what you need to.


Revolving credit is a type of borrowing where the available funds are automatically renewed as the borrowed money is paid off. This differs from other types of loans, such as bank loans or SBA loans, where you borrow a fixed amount all at once.

Most lines of credit are a type of “revolving credit”. Revolving credit is a type of borrowing where the available funds are automatically renewed as the borrowed money is paid off. This differs from other types of loans, such as bank loans or SBA loans or mortgage loans, where you borrow a fixed amount all at once. With those types of loans, once you start paying back the money, there is not an option to borrow again back up to the original loan amount.


Many people are familiar with some other common forms of revolving credit: credit cards and home equity lines of credit (HELOC’s). Credit cards provide a set credit limit, or spending limit, and you can use however much of your available spending limit you want whenever you want. HELOC’s are another form of revolving credit. With these, you have a set maximum amount you can borrow, and your home serves as collateral for the borrowed money.



What is a revolving line of credit for business?


A revolving business credit line is a flexible method of borrowing for your business. Instead of borrowing a fixed amount of money all at one time, a revolving line of credit allows your business to borrow money in smaller increments. It is really just another way of describing a business credit line or business line of credit.


With a revolving line of credit for your business, you borrow what you need, when you need it, up to a pre-approved maximum amount. You then make payments on a regular, pre-established schedule, and you can choose to borrow or use more as you pay down your outstanding balance.


Revolving credit lines can be a very important tool for small business owners to help keep operations moving forward smoothly even with the ups and downs in cash flow so many businesses experience. Having a revolving credit line available can be critical for your business to allow you to take advantage of opportunities when they arise even if you don’t have all the needed cash on hand.


When you hear the term small business line of credit, this almost always refers to a revolving line of credit. Because of the cyclical nature of so many businesses, a business may need to borrow money at irregular intervals to meet short-term needs. A small business line of credit can be a perfect option for effectively managing your business cash flow.


A revolving small business credit line can help a business in so many ways, whether addressing short-term expenses or just generally helping to manage cash flow ups and downs. Examples of these common needs can include business expenses like paying bills, covering payroll, replacing equipment or dealing with unexpected cash flow shortages.


Is a revolving line of credit a good fit for my business?


In an ideal world, your business has cash reserves at all times to help you in times of need. Yes, that’s in an ideal world! For so many businesses, however, cash reserves are available sometimes but are not plentiful at other times. For businesses without a deep consistent reserve of cash, a business line of credit is the next best thing.


With a business line of credit, you have access to funds whenever you need them, but you don’t have to use them or pay interest on them when you don’t need them. The funds available with a small business line of credit are like having cash reserves available only if and when you most need them.


A revolving line of credit is also a good fit for your business when you have working capital needs that change from time to time, but your revenue stays very constant. For example, a business line of credit can give your business needed funds to make unusual purchases, buy additional inventory or make one-time investments.



What is a business credit line best used for?


Typically, a business credit line is best used for short-term or medium-term working capital needs. Examples of this are covering payroll for new employees before they start generating revenue, or purchasing inventory during an unusually busy period or to fulfill a large order or contract.


If you believe you'll need some additional business cash soon, but you're not sure exactly how much cash you'll need or when you’ll need it, a small business credit line is great for that too. A business credit line offers a great combination of flexibility and access to funds. You have access to cash when you need it, but you’re not paying interest on funds you don’t use.



Revolving line of credit vs. business credit cards?


As discussed, a revolving line of credit is similar in some ways to a credit card. Still, the two are different in some important ways. First, credit cards tend to have higher interest rates. Also, credit cards charge additional fees for cash advance and balance transfers.


Credit cards may require monthly payments that are higher than the minimum payments on a business line of credit. Also, the business line of credit borrowing amount is almost always higher than the amount you can access through a credit card.


Business credit cards are unsecured loans, and therefore they usually require personal guarantees. This makes you personally liable for any unpaid debts. For most businesses looking to grow with access to working capital, a small business line of credit is the better option.



Revolving credit vs. non-revolving credit?


Most traditional bank loans, including SBA loans, are non-revolving credit. With non-revolving credit, you borrow a fixed amount and you receive that full amount when the loan is made. With non-revolving credit loans, you're not able to reuse funds once you've paid down the outstanding balance.


Non-revolving credit loans do usually have lower interest rates, and they offer predictable payment schedules. However, they lack the flexibility of revolving credit. Revolving credit allows you to use any amount of funds up to the approved limit, and once you pay down the balance some, you can borrow again up to the limit.


Revolving credit vs. installment loans?


Installment loans refer to borrowing a set amount of money and having set repayments you make until the loan is fully paid-off. Traditional bank loans and SBA loans are examples of installment loans.


An installment loan is usually a longer-term financial proposition, often used for large business purchases, such as buying property, equipment or opening a new location. They are not flexible and do not allow borrowing again after the initial loan is made.


By contrast, revolving credit is open-ended, which means you can borrow as much as you want within the approved maximum without having to reapply each time. Regardless of the amount you can borrow, you are only paying interest on the amount you actually use.



What are examples of using my small business line of credit?


Let’s look at a couple of real world examples of using a line of credit for your business. You can use your revolving business line of credit for almost any business reason, but for our examples, let’s look at two possible reasons.


Example 1: Suppose you run a restaurant and you have one room in your restaurant that needs repairs before you can use it again. You want to quickly get the funds to do the work, and you know that once the space is reopened your sales will increase from the additional tables. A business line of credit could be perfect for you.


With a traditional loan, you’d have to borrow the whole amount and pay interest on the full amount from day one. With the line of credit, you use the money only once you have contractors to pay or materials to buy. You may end up using less money than you expect, and you’ll only pay for the amount you do use. Once the new room is open, you’ll generate more sales every week, and you can pay off the line potentially within weeks or months.


Example 2: Let’s assume you’re ready to hire two new sales people. You’ll have to pay them during their training period, and they aren’t expected to generate revenue for you for at least 2 months. Again, a business line of credit could be a perfect solution to provide the cash you need to increase payroll while the new salespeople train and ramp-up.


A small business line of credit is great in this case because you won’t have to pay interest on the full amount you’re approved for. You only have to pay interest as you borrow the funds. You’ll pay the new employees over time, so you’ll only draw funds periodically as needed.


In both cases above, once you pay back the amount borrowed, your small business line of credit is fully available again for you to borrow from when the need next arises. And while it’s all paid back and you have no amount outstanding, your business won’t have any interest expense at all.


 

About the Author


Mike Spitalney

Mike Spitalney is the CEO and founder of Everfund. Mike is on a mission to help small businesses get the best financing for their needs and avoid the confusion and complexity of today’s lending world. Over two decades, Mike and Everfund have helped thousands of businesses thrive and grow using a variety of short and long-term loan options, from working capital loans and lines of credit to SBA and bank loans and commercial mortgages. Outside work, you'll usually find Mike outside running, hiking or biking.


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