A small business line of credit (LOC) allows you to draw against a predetermined credit limit as you need it, instead of receiving the full loan amount at one time like a term loan. Every draw you make must be repaid, with interest, over a set period of time. This makes lines of credit best for covering smaller business expenses.
How a Small Business Line of Credit Works
A business line of credit is a type of small business loan that you can draw against as you need funds. It’s typically used for short-term working capital to help improve cash flow or to finance the costs of unexpected expenses. It also lets you borrow funds again after repaying a draw, which means it’s readily available to fund your cash flow needs.
These credit lines are similar to a credit card where the line is open and available for you to use, and you only pay interest on the part of the line you draw. It’s a great way to get access to cash that you can put into your business on a moment’s notice. Unlike a credit card, your business line of credit must be repaid within a certain time frame, so you cannot carry a balance indefinitely.
The availability of funds for a line of credit differs from a short-term business loan. Unlike a short-term business loan as you pay down the balance on your line of credit, you increase the amount available to draw in the future. Once you establish a credit line, drawing funds from it is usually the fastest way for your business to access capital for quick payments or unexpected events.
How to Select a Business Line of Credit
To get a business line of credit, you can work with several online and traditional providers. While each offers the same fundamental product, there are differences in the minimum qualifications, amount of funding, repayment terms, and overall costs that are important to consider for your business.
$100,000 or more
Less than $100,000
Two to four weeks
One to three days
720 or higher personal credit
600 or higher personal credit
Up to 25% APR
8% to 75% APR
Ask yourself certain questions to select the right business line of credit.
How Much Funding Do I Need?
Credit lines typically have smaller borrowing limits than term loans, which makes them ideal for unexpected charges but not for large capital investments. If you’re looking for more than $100,000 in funding, then you’ll want to consider a traditional bank. Anything less than $100,000 makes you a good fit for an online lender.
How Soon Do I Need Funding?
If you need initial access to funds quickly upon applying, then you’ll want to look at an online lender that can get you funded in as soon as one day. Short-term loans are generally quicker to obtain from scratch but drawing from an established line of credit is even faster. Once you’re approved, you can typically access your funds at any time.
Can I Meet the Minimum Qualifications?
Traditional banks have high minimum qualifications and sometimes require specific collateral. Online providers can be far more flexible, requiring lower minimum credit scores and often offering unsecured business lines of credit. However, the tradeoff is the higher cost and smaller funding amount that online lenders offer.
Can I Afford the Borrowing Costs?
Banks offer more affordable credit lines than online providers, but when used for high-return on investment (ROI) opportunities, online small business lines of credit can also be a great option. Additionally, if your bank is offering you a longer repayment term on your credit line, then it could end up costing you more than the short-term online lenders that offer repayment terms of six or 12 months.
What a Small Business Line of Credit Can Be Used For
Ideally, a business line of credit is used for short-term working capital, unexpected costs, unique purchasing opportunities, or to offer credit to your customers. It’s not intended to be used to make big capital purchases like real estate or heavy machinery or as a way to afford normal operating expenses on a regular basis.
Four purposes business owners use a business line of credit for include:
- Short-term working capital: LOCs are often used to get working capital to make payroll or to cover expenses when seasonal business is slow or while waiting for customers to pay you.
- Safety net for unexpected costs: Some businesses open a line of credit before they need any cash and then use it to pay for unexpected expenses when they come up. For instance, if a refrigerator at your restaurant needs an emergency repair, a business line of credit would come in handy to finance a quick fix to the problem.
- Taking advantage of unique purchasing opportunities: A business’s wholesaler may have a one-time deal for goods the business purchases frequently or a wholesaler may have a special sale because it’s going out of business. Having credit to buy in bulk when these opportunities appear can save your business money in the long term.
- More confidently offer trade credit to customers: According to recent studies, 81% of businesses have invoices in accounts receivable that are 30 days past due or more. With a small business line of credit, you can be more confident in offering trade credit because you know you have a safety net available if a client is slow to pay.
The further you get away from using your small business line of credit for the above uses, the more likely it is that you’re using a less than optimal financial product. Using the wrong financing product can result in unnecessary interest expenses for your business.
When to Apply for a Small Business Line of Credit
The best times to apply for a line of credit are when your credit score is high, revenues are increasing, your business hit a big milestone, or before you need the capital. Applying for a line of credit at the right time can position you to be approved for a larger limit, lower interest rate, and more comfortable repayment schedule.
You should apply for a business line of credit:
- When your credit score is strong: Check your credit and make sure it’s looking as good as it can be. If something is being misreported, dispute it, and apply for the line of credit once the dispute is resolved. If you need to pay down some revolving debt to improve your score, do so.
- While revenues are trending up: Putting your best foot forward means applying for a line of credit when revenues are up, and you aren’t desperate for financing. Since you’re not paying interest until you draw on the line of credit, applying for the line before the funds are needed is a no-brainer.
- When you hit a key business milestone: If you hit a new benchmark like making it to the two-year mark as a business or boosting your credit score by 50 points after paying off some old bills, consider requesting an upgrade to your existing business line of credit or shopping around with some next tier lenders.
- Before a capital need: By planning for your expenses, you can apply for a line of credit in anticipation of a cash flow shortfall. This can help improve your chances of receiving funding because your business isn’t facing an immediate issue.
Pros & Cons of a Business Line of Credit
With a business line of credit, your business can enjoy on-demand funding while only paying interest on the funds you use. You also won’t have to apply for funding every time you need credit. However, credit limits are often smaller than with a term loan, and your limit can be reduced or canceled altogether by your lender.
- Draw funds whenever needed: With a business line of credit, you can draw funds whenever your business has unexpected expenses or cash flow shortages.
- Pay interest only on the funds you use: By borrowing exactly as much as you need, your interest costs will be much more manageable.
- No need to reapply for more funding: By repaying the draw on your line of credit, your credit limit will be restored, and you can use the funds repeatedly without reapplying for financing.
Cons of a Business Line of Credit
- Typically fund smaller amounts than term loans: Because a line of credit is revolving, lenders typically offer smaller funding amounts for it than they would for a term loan.
- Not a good solution to long-term working capital problems: A line of credit is a great option for managing any short-term cash flow issues. However, it shouldn’t be used to manage chronic or long term cash flow issues. By adding interest payments to your cash flow shortages, you could potentially find yourself unable to make payments.
- Credit limit can be reduced or canceled by the provider: Your lender often reserves the right to reduce your credit limit or cancel the line of credit. This happens if you don’t make timely payments or your business, and your creditworthiness is not doing well. However, if things improve, lenders will often increase your credit limit automatically.
A small business line of credit can be an affordable solution for both short-term working capital and emergency financing. However, it requires you to plan your application in advance to get the best rates and terms. Your best line of credit option is through a traditional bank, but its qualifications are tough to meet. It’s easier to qualify with online lenders, and you’ll get funded much quicker.