Pros and Cons of Receiving a Business Line of Credit
To help you determine if a line of credit is right for your business, we’ll detail what this financing product is, how it’s used, and what the pros and cons are.
What is a Business Line of Credit?
You might be wondering, how does a business line of credit work?
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. The exception is that with a line of credit, you can withdraw cash to cover whatever expense you need to pay for.
This makes a business line of credit different from a business credit card because as a borrower, you’ll receive cash to cover costs that couldn’t otherwise be purchased with a credit card.
It’s important to note the differences between revolving and non-revolving line of credits. 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.
In comparison, non-revolving credit is a lump-sum financing that’s received all at once. When you pay off your line, it closes.
In addition, you should be aware of secured and unsecured business lines of credit prior to 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 businesses struggle to qualify for secured 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 defined as your current 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, you’re going to have times when working capital is tight, which can present challenges. Working capital enables you to operate your business, allowing you to afford payroll, maintain inventory, and pay for other consistent costs like rent and utility bills. Below, we’ll explain some of the benefits that a business line of credit can provide to 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 for some businesses than others.
For example, a retail store that makes most of their sales during the holiday season may be short on cash during other times throughout the year, making it difficult for them 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. Also, depending on the agreement with your lender, you may be able to pay off the balance at any time without a prepayment penalty.
3. Improves Business Adaptability
There may be times in which you have a limited window to take advantage of opportunities. For instance, let’s say you’re a manufacturer and your supplier’s costs are significantly reduced. You’ll want to take advantage of that limited-time offer, but you might not have the cash to afford it. With a business line of credit loan, you won’t miss out on a great 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, to get the best terms (and avoid higher interest rates) on personal loans, you need a long personal credit history. 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 great way to achieve this. Just be sure to pay if off responsibly, so that you don’t lower your score!
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 responsibly utilize this financing option.
With that said, the cons of a business credit line begin with the fees.
1. Extra Charges and Fees
While business lines of credits’ pay-as-you-go format may make it seem ideal, the fees can quickly add up. These additional costs will vary from lender to lender and will 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 be asked to provide the following information:
- Business and personal tax returns
- Bank account information
- Checking account information
- Business planning documents
- In some cases, you may be asked to undergo 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 less 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 useful as you make it. Thus, it should only be used as an insurance policy for cash flow shortages. Using it excessively is a recipe for disaster, but for many it’s a real temptation. If your business has already acquired significant debt, or you simply 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
In comparison to other financing options, lines of credit typically come in relatively low borrowing amounts. So, if you need money to afford an upcoming expansion project, new equipment, or another costly business expense, you might be better off getting financing through another method.
Conclusion: Decide if a Business Line of Credit is Right for Your Company
As with any decision to take on debt, consider if a business line of credit is right for your company. It can be an extremely useful tool for savvy small business owners, but 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 November 2020
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.