Business Line of Credit: What It Is & How It Works

A small business line of credit is a financial tool that provides entrepreneurs and small business owners access to cash that they can use to meet short-term funding needs. When you use a business line of credit, you only pay interest on what you borrow. You can pay your balance down over time; once you do, you can borrow the same funds again.

In this guide, we’ll explain what business lines of credit are, how they work, and when they’re best for small businesses.

What is a Small Business Line of Credit

A small business line of credit is a type of loan that gives a business access to a fixed amount of money, which it can use according to its need for cash flow. Unlike a traditional loan, where you receive a lump sum of money upfront and start paying interest on the full amount immediately, a line of credit is more like a credit card. You have a maximum amount you can access, but you only pay interest on the money you actually borrow. 

Once you borrow against a line of credit, you’re only responsible for monthly interest payments. When you have extra money, you can pay down the balance. Once you have, you can borrow the same money again. This offers businesses more flexibility to manage their cash flow, invest in new opportunities, or handle unforeseen expenses.

How a Small Business Line of Credit Works

A small business line of credit works similarly to a credit card. A lender sets a maximum credit limit, and the business can access as much or as little of that credit as it needs when it needs it. 

Once you repay any money you borrow on a line of credit, the business can draw down again up to the maximum limit. Periodically, the lender may review the line of credit to decide whether to decrease, increase, or maintain the credit limit based on the company’s repayment history and financial stability. 

Where business loans may be more suitable for larger, one-time investments due to their potentially higher loan amounts and fixed repayment schedule, a line of credit offers more flexibility. This allows businesses to borrow up to their credit limits as needed, which may be better suited for managing ongoing operational expenses.

How to Get a Small Business Line of Credit in 5 Steps

If your business is just starting or you have poor credit, a business line of credit may not be an option. Follow the following steps to apply for a small business line of credit:

1. Assess your needs: Understand why you need a line of credit and how much you require. This involves a deep analysis of your financial situation and future business plans and prospects.
2. Review your credit score: Your business (if established) and personal credit scores play a crucial role in getting approved. Review both scores and find ways to improve them if needed – this may involve paying off existing debt or disputing any debts that shouldn’t be on your credit report.
3. Prepare your business documentation: Lenders typically ask for documents like financial statements, tax returns, and a business plan. Get these documents together to make sure you have them ready.
4. Research and compare lenders: Not all lenders offer the same terms. Research multiple lenders, taking into account their interest rates, terms, and customer reviews.
5. Apply for the line of credit: Once you have all your documents in order and have chosen a lender, it’s time to apply. Some lenders allow online applications, while others may require a face-to-face meeting. One note is to beware of any lender who charges an upfront application fee with no approval guarantee.

Pros and Cons of Small Business Lines of Credit

Like any type of financing, a small business line of credit has advantages and drawbacks. Understanding these will help you decide whether this type of credit is suitable for your specific needs. Here are some pros and cons of a small business line of credit:

Pros

• Flexible borrowing limits and draw schedules: With a small business line of credit, you can borrow as little or as much as you need within your limit and only pay interest on what you borrow. This flexibility can be crucial for managing cash flow or handling unexpected expenses, making it an excellent tool for small businesses that need access to capital but also want to keep their borrowing costs low.
• Interest only accrues on the used amount: With traditional loans, you pay interest on the entire loan amount from the start. With a line of credit, on the other hand, you only pay interest on the actual amount you borrow. If you don’t use the credit, you don’t pay interest. This can make lines of credit a more cost-effective financing option, particularly for businesses with fluctuating capital needs.
• A reusable source of funds: When you pay down or pay off what you’ve borrowed on a line of credit, you can use those funds again. This revolving nature makes a line of credit a reliable source of ongoing funding, unlike a traditional loan.
• Boosts business credit: Regular, responsible use of a line of credit can help improve a business’s credit score. Like with a personal credit card, timely repayments and low debt levels will reflect positively on your business’s credit. This can help your company get more favorable terms on future loans or lines of credit.
• Helps with cash flow management: A line of credit can benefit businesses with cyclical or seasonal cash flow. During slow periods, companies can borrow against their lines of credit to cover expenses. When business picks up again, they can repay the line of credit. This can help ensure the business always has enough cash to meet its obligations, even during slow times.

Cons



• Can encourage over-borrowing: Because funds are easily accessible in a line of credit, businesses can sometimes borrow more than they need. Over time, this can result in substantial debt that may challenge the business’s financial stability.
• Variable interest rates: Most small business lines of credit come with variable interest rates, which can increase or decrease over time based on prevailing interest rates. If rates rise significantly, the cost of borrowing can become relatively high. 
• Fees and penalties: Some lines of credit come with annual fees or maintenance fees that can add to your cost of borrowing. Furthermore, you could be hit with additional fees and penalties if you fail to make your payments on time. 
• Requires good credit: Lines of credit often require a good credit score for approval. Businesses with a poor credit history may find it challenging to secure a line of credit. They may face higher interest rates and less favorable terms if they do.
• Periodic reviews: Lenders often review lines of credit periodically and can choose to decrease the credit limit if they perceive the business to be at a higher risk. These reviews can cause uncertainty, especially if the business relies heavily on the line of credit for its cash flow needs.