The Top Pros and Cons of Securing a Line of Business Credit
However, although a line of credit can be a viable financing option, it’s essential to review the pros and cons of this product before applying.
To help you determine if a line of credit is right for your business, we’ll review this financing product and the pros and cons.
Business Line of Credit Definition
As a small business owner, you might be wondering, how does a business line of credit work? Even if you’ve received a personal line of credit or home equity line of credit (HELOC), you might not fully understand how businesses can secure this type of funding.
A business line of credit is similar to a credit card in that you can use it whenever needed, as long as you don’t exceed the established credit limit. When you receive a business line of credit, you’ll receive a maximum amount that you can borrow against that you can use for any business cost.
As a borrower, you’ll receive cash to cover costs that couldn’t otherwise be purchased with a credit card, such as expensive equipment.
The Different Types of Business Credit Lines
It’s important to note the differences between revolving and non-revolving lines of credit. With revolving credit, you can spend up to the credit limit. Even if you don’t use the credit, it won’t expire or close, making it a flexible, long-term financing option.
In comparison, non-revolving credit is a lump-sum financing option with a fixed draw period. When you pay off your credit line, it’ll be closed, so you’ll have to re-apply for future financing.
In addition, you should be aware of secured and unsecured business lines of credit before applying. Simply, a secured line of credit can be procured if you submit collateral, while an unsecured credit line doesn’t require it. Often, new entrepreneurs struggle to qualify for secured business lines of credit because they either don’t have collateral to submit or can’t afford to do so.
The Pros of a Business Line of Credit:
Working capital is your current business assets minus your current liabilities. In other words, it’s the amount of cash (or cash equivalents) that your business has, minus your short-term debt obligations.
As a business owner, there will be times when working capital is tight, which can present challenges. Having access to working capital is crucial because it’s needed to afford payroll, maintain inventory, and pay for other costs like rent and utility bills.
Below, we’ll explain some of the benefits of having a line of credit for your small business.
1. Improves Cash Flow During Slow Seasons
For many businesses, a line of credit is the ideal tool for balancing cash flow. Of course, this is more applicable to some companies than others.
For example, a retail store that makes most of its sales during the holiday season may be short on cash during other times throughout the year, making it difficult to make payroll. Because you can’t use a credit card to pay your employees, a small business line of credit is the logical solution for this type of business.
2. Allows You to Pay for What You Use
When you receive a credit line, you only pay interest on the amount that you use.
Depending on the agreement with your financial institution, you may be able to pay off the balance at any time without a prepayment penalty. However, in most cases, you’ll be required to make a minimum monthly payment on the amount that you’ve used.
3. Improves Business Adaptability
There may be times when you have a limited window to take advantage of opportunities. For instance, let’s say you’re a manufacturer and your supplier offers you a discount price. You’ll want to take advantage of that limited-time offer, but you might not have the cash to afford it.
Once you receive a business line of credit, you won’t miss out on an excellent opportunity to save money in the long run!
4. Builds Business Credit
Another positive aspect of a business line of credit is that it can help build your business credit history.
For instance, you need a long personal credit history to get the best terms (and avoid higher interest rates) on personal loans. The same goes for business credit, and a commercial line of credit can be instrumental in this pursuit. If you’d like to boost or maintain your credit score, receiving a business line of credit can be a fantastic way to achieve this.
However, it’s crucial that you pay it off responsibly to avoid lowering your business or personal credit scores!
The Cons of a Business Line of Credit:
As with any capital source, a business line of credit has its downsides. Without examining potential issues that could arise, you won’t be prepared to utilize this financing option responsibly.
With that said, the cons of a business credit line begin with the fees.
1. Extra Fees
While business lines of credits’ pay-as-you-go format may seem ideal, the fees can quickly add up. These additional costs will vary from lender to lender and depend on the other agreement terms.
Ultimately, don’t be drawn in by a low-interest rate just to be slapped with numerous fees later. It’s crucial that you conduct your research and compare online lenders’ annual fees and other additional costs. By doing this, you can either find the right line of credit for your business or determine if another financing product will be more affordable.
2. Difficult to Qualify For
To apply for a business line of credit, you’ll need to supply financial statements detailing your business’s annual revenue and cash flow. You’ll also need to provide the following information:
- Business and personal tax returns
- Bank account information
- Checking account information
- Business planning documents
- In some cases, your lender may conduct a yearly review to maintain your credit line.
Often, you’ll need two years of business history to qualify for a line of credit. While some of this information is standard, you may be able to procure other types of financing that will come with a shorter application process and fewer requirements. These options may include a small business loan, cash advance, or business credit card.
3. Potential for Misuse
A business line of credit is as helpful as you make it. Thus, it should only serve as an insurance policy for cash flow shortages. Using it excessively is a recipe for disaster, and for many, it’s a real temptation.
If your business has already acquired significant debt, or you aren’t confident that you’ll be able to repay your balance, this might not be the right time for you to take on a line of credit.
4. Low Borrowing Limits
Compared to other financing options, lines of credit typically come in relatively low borrowing amounts. Therefore, if you need money to afford an upcoming expansion project, new equipment, or another costly business expense, it might be better to apply for a term loan.
Conclusion: Determine if a Line of Business Credit is Right for You
As with any decision to take on debt, consider if a business line of credit is suitable for your company. Although a credit line can be a handy tool for savvy small business owners, it isn’t for everyone.
Lastly, a word to the wise from Entrepreneur is to apply for a business line of credit when you don’t require it. That way, when you do need it, you aren’t negotiating with your lender from a position of weakness.
Editor’s Note: This post was updated for accuracy and comprehensiveness in April 2022.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.