How Does a Short-Term Line of Credit Work?
In fact, a study by U.S. Bank revealed that 82 percent of small businesses fail because of poor cash flow management. To smooth uneven cash flows, many business owners turn to short-term credit as a flexible solution. In addition, it can be more cost-effective and convenient than a credit card or bank loan.
In this post, we’ll explain what this form of credit is, how you can qualify, and how to determine if it’s right for your business.
What is a Short-Term Line of Credit?
A line of credit can provide your business with access to funds that can be used for both routine and unexpected expenditures. Unlike a traditional bank loan, you don’t need to specify how you’ll use the line of credit to be approved.
Instead, a business line of credit operates more like a credit card. With a credit line, you’ll receive a fixed amount of credit that’s available when you need it. Then, you can repay borrowed funds all at once or in periodic installments.
Although short-term credit lines have many advantages, but they’re not right for everyone. Before determining the best short-term financing solution for your business, consider a few key questions.
Is Short-Term Credit Right for Your Business?
1. How Do You Plan to Use the Funds?
Business lines of credit are designed to help you meet your short-term working capital needs, such as payroll, inventory purchases, or equipment repairs. A line of credit can also be used to address emergency expenses or take advantage of strategic business opportunities when you don’t have the necessary cash available. If you regularly experience fluctuations in cash flow and require additional funds on-demand to cover expenses, a business line of credit can be a great option.
On the other hand, if you’re seeking capital to expand your business or make a large purchase, a line of credit probably isn’t the best solution. Because lines of credit often come with higher interest rates in comparison to traditional types of loans, it can be challenging and expensive to pay back your borrowed loan amount.
2. How Quickly Can You Repay Borrowed Funds?
If you’re applying for a revolving line of credit, repayment terms will typically be more flexible than they are with a traditional loan. While you’ll need to meet the minimum monthly payments, you can pay more or less each month depending on your business’s cash levels.
In addition, interest rates on business lines of credit typically follow the prime lending rate, so your interest rate may fluctuate over time. Since you’ll start paying interest as soon as you use your line of credit, you should try to repay your balance quickly. If you need more than a year to repay borrowed funds, a business loan may be more cost-effective.
3. How Strong is Your Credit History?
Short-term lines of credit can be easier to obtain than traditional business loans. Still, most financial institutions will only consider established businesses that have at least two years of operating history and a proven track record of growing revenues and profits. If your business is still in the start-up phase, alternative sources of funding may be more appropriate.
However, if you own an established business, but your credit rating is weak, a line of credit can be a great way to build your credit score. By keeping a low balance and making your loan payments on time, you can establish yourself as a reliable borrower. This will ultimately make it easier to secure funding from lenders and investors in the future.
Conclusion: Decide if a Short-Term Credit Line Will Benefit Your Business
Like any source of business financing, short-term lines of credit have their advantages and limitations, and only you know what’s best for your small business. If you operate in a seasonal industry or simply need help meeting routine expenses, a line of credit can make it easier to manage your cash flow. By staying within your borrowing limits and repaying your balance quickly, you can build a strong credit history and increase your likelihood of obtaining more significant sources of capital down the road.
Editor’s Note: This post was updated for accuracy and comprehensiveness in September 2019.
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.