How Does a Business Line of Credit Work?

A third of new businesses start with less than $10,000,1 so you certainly aren’t alone if you started your small business with modest funds. But as your business grows and you need financial flexibility, you might wonder, How does a business line of credit work?

Growing up comes with a greater appreciation for flexibility. A kid might run around all day without a care. But as an adult, a friendly game of flag football may come with a few creaks and groans, and you quickly remember why you should stretch before and after a workout. Stretching helps your body be more flexible to effectively react to future stresses.

As your small business grows, you might gain a similar appreciation for financial flexibility. Even a careful eye on your business’s cash flow won’t prepare you for unplanned expenses or sudden opportunities for expansion.

Keeping a line of credit for your business is a little like stretching when you exercise—your company can react more quickly and more easily to any financial stresses thanks to proper prep work.

Note

Keeping a line of credit for your business is a little like stretching when you exercise—your company can react more quickly and more easily to any financial stresses thanks to proper prep work.

Let’s cover the ins and outs of lines of credit so you know how this financial tool can help your business adapt to problems and prospects on the fly.

We’ll also discuss what requirements and term conditions to expect and how a new business can secure such financing.

We’ll also explore where small businesses should look for lines of credit—then you’ll know where and how you can find the flexibility your business needs to prosper.

How does a business line of credit work?

When a lender gives your small business a line of credit (LOC), they give you a set credit limit. You can access any amount of money up to that limit for your business and repay that money back over time with an added interest fee.

So how is a business LOC different from other types of financing, such as term loans and business credit cards?

Best business lines of credit
Lendio
Best overall
BlueVine
Easiest application
Funding Circle
Best for established business
OnDeck
Most leniant
Wells Fargo
Big bank option

Lines of credit vs. term loans

A term loan provides your business with what’s called a lump sum of cash, meaning you get the full amount at the start of the loan. Then your business pays back that amount (with interest) over a specified number of payments.

In contrast, a line of credit is revolving credit—it allows you to borrow money and repay it as many times as you need. If your lender lets you pay off your balance early, you can save a lot of money by dodging interest costs.

As mentioned before, you’ll have a maximum total amount you can withdraw at any time called a credit limit, which is usually smaller than a term loan to compensate for the more flexible withdrawal and repayment structure.

Lines of credit vs. business credit cards

A line of credit shares even more in common with a business credit card. However, the key differences involve the use of cash and reward incentives.

A line of credit is revolving credit—it allows you to borrow money and repay it as many times as you need.

While it’s usually tough to get cash from a business credit card, it’s much easier with a LOC. But if you love the sweet rewards you get from many business and personal credit cards, you’ll be missing out on those rewards with a line of credit.

Lines of credit vs. other financing options

Each type of business financing comes with its own strengths and weaknesses. Many businesses will take advantage of multiple forms of financing at different stages of the business or for different purposes.

A business credit card works great for day-to-day spending. A term loan helps your business with purchasing new real estate. And a line of credit can smooth out month-to-month expenses because of its flexibility.

Common business line of credit requirements

Banks and credit unions will usually want your business to prove solid revenue over multiple years before they offer you a line of credit. But you’ll generally get higher limits and lower interest rates for your trouble.

Online lenders will require less for your application—just be prepared to pay more in rates and fees once you start borrowing that money.

Here are some different documents you’ll likely need for an application with any potential lender.

1. Basic business information

You’ll need to provide your business name, employer identification number (EIN), and entity type (such as an LLC, S corporation, or sole proprietorship). The lender will also want to know what industry you work in and how long your business has been operating.

2. Tax returns

Depending on how your business is taxed, your lender might need to look at either your personal or business tax returns—or both. Pass-through entities, which bypass corporate income taxes, will probably need to show personal tax returns.

Traditional corporate structures will likely need to provide business tax returns so the lender can check on business revenue and expenses.

3. Bank statements

In addition to tax returns, a bank or other lender might want to see a few or even several months of business bank statements. This lets them check your more recent financial history for any cash flow concerns—they need to know you have enough short-term working capital.

4. Contracts

On top of your bank statements, a lender might need to examine various contracts that could affect financing. These contract reviews are especially relevant if you’ll use the LOC to pay for a contract or business agreement.

5. Leases and loans

Regular monthly payments might show up in some of the documents mentioned above, but your lender may want a look at any leases you have with other parties to see what the specific contract terms are.

The lender might also want to see your accounts receivable to examine how well your business collects on any funds you’re owed.

6. Ownership approval

If you have multiple owners, you might also need multiple signatures to show approval for the line of credit.

Different lenders will have different rules here, but if you do need other authorizations, you may have to provide additional information for any other owners.

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Business line of credit repayment interest rates and terms

The best bet for approval for your business is often the bank or credit union where you hold a business account. Using the same bank streamlines some of the application process, and the added familiarity can’t hurt your chances if you’re on the edge of approval.

There are many business lines of credit options available, so it’s wise to look into multiple offers. Here’s a quick review of common interest rates, credit limits, and terms for different lenders.

Best business lines of credit lenders

Lender/loan marketplaceInterest rateCredit limitAdditional feesGet credit
Lendio8%–24%$1,000–$500,000VariesApply now
Wells FargoPrime + 1.75%$5,000–$100,000$95–$175 annual feeApply now
Bank of America2.99% for first year$10,000–$100,000$150 origination feeApply now
ChaseBased on Prime Rate$10,000–$500,000$150–$500 annual feeApply now
OnDeckStart at 13.99% APRUp to $100,000$20 monthly feeApply now
FundboxStart at 4.66%Up to $100,000NoneApply now
PNCBased on Prime Rate$20,000–$100,000$175 annual feeApply now
Data effective 11/4/18. At publishing time, prices and rates are current but are subject to change. Offers may not be available in all areas.

Finding a business line of credit for new businesses

The idea of pitching your new business plan to a bank for startup funds makes for great television, but unfortunately, it isn’t often successful in real life. Lenders tend to rely on numbers and formulas to protect themselves from bad deals. Most lines of credit will need your business to be around for at least a year or two so lenders can crunch the numbers. They’ll also want to see promising revenue.

Some lenders will offer an LOC with a smaller credit limit to newer businesses, which helps minimize their risks. Other lenders might offer SBA-backed loans, which could give you pretty good terms if your small business meets the requirements.

One of the most important things you can do to secure any type of business loan is to improve your business credit score, since business credit is an indicator of trustworthiness. But how can you do that?

A brief guide to building business credit

First, you’ll need to make sure your business is official to credit bureaus and lending companies. Grab an employer identification number (EIN) from the IRS, choose an entity designation, and make sure your business address and phone number are separate from your personal ones. You’ll also want to open a separate bank account for your business.

Next, you’ll want to get another number: a D-U-N-S number from Dun & Bradstreet. That number will allow you to begin a credit file with the well-known business credit bureau.

Then, you need to start building credit any way you can. Trade lines with your suppliers are one of the simplest ways to accomplish this as a budding new business; if you don’t currently have a viable supplier, well-known companies like Home Depot or Office Depot provide trade credit terms for businesses.

Short-term financing, either through a business credit card or small, short-term loans, can also be a good first step to build credit for a LOC approval. Either of these options will build confidence in your credit while also helping your business manage its short-term capital.

Finally, don’t forget to make payments. Otherwise, your business credit score won’t be moving in the direction you want. And be sure to follow up with any trade line suppliers to make sure they’re reporting your repayment to credit agencies.

How to get business lines of credit without personal guarantees

Many lines of credit will require a personal guarantee from small-business owners. A personal guarantee means the credit is unsecured, so you won’t be including specific collateral like your home. But that doesn’t mean you escape any personal consequences if you don’t repay the loan.

Instead, you—as the loan’s cosigner—will be next in line for creditors if your business fails to pay its debts. Obviously, that makes things risky for you if the business starts to struggle.

This gamble balances out the risk a lender takes when so many small businesses fail in their first few years. You might be able to spread out your personal risk with the other owners or investors in your business (if you have them), with your spouse, or through securing the loan with alternate collateral.

You can also get lenders to waive a personal guarantee if they have enough evidence that you’re a safe bet to repay your line of credit. That evidence comes from your years in business, your past history with the lender, and a solid personal or business credit score.

To build up your credit score, you can take the steps we mentioned above. If you want to build up your score quickly, try and find trade lines with many different suppliers and use financing wherever it makes sense.

The longer you work with a lender, and the smaller that lender is, the more bargaining chips you have as a borrower. A big bank will note how long you’ve worked with them, but a smaller credit union or alternate lender will have more motivation to benefit from your continued business.

In the end, if you want to avoid a personal guarantee on your LOC, you might just need to wait it out. The longer your business has been around and the longer it generates revenue, the safer you’ll appear to potential lenders.

Where to get your business line of credit

Pretty much any bank or credit union will offer some type of line of credit, so you might want to check with them first. As described in the section above, the smaller and more community-focused the lender, the more incentive they have to work out a deal with your small business.

Online lenders are another option. You’ll usually pay more in fees and interest rates, but the more relaxed qualifications can get you a LOC more easily.

Take your time and look for the right line of credit for your business. It’s nice to have financing right away, but finding the best possible terms will give you even better flexibility going forward.

Takeaways

Just as physical flexibility takes a conscious effort, getting flexible funds through a line of credit will take some effort as well. But the adaptability pays off when unpredicted costs or opportunities to grow come your way.

If your business is brand new, you might have to wait, but make sure to build your business credit score while you do. Look for opportunities to show lenders you’re ready to take on additional credit. You can also find an alternate lender if you need the LOC right away.

As business owners, what have been your experiences with lines of credit? We’d love to hear how you’ve experienced the flexibility of a line of credit and what surprised you while applying for one.

Source

1. U.S. Small Business Administration, “Dissecting Access to Capital