Being your own boss is a tricky dream.
On the upside, entrepreneurship comes with all the freedom in the world. For the self-employed every day is casual Friday and the workweek doesn't have to start before Tuesday if you'd rather it not.
On the other hand, entrepreneurship comes with all of the stress of running your own business. You can't simply be good at your chosen profession. You also need the smooth talk of a salesman, the number-crunching of an accountant, the chops of an effective marketer and the organization of a great office administrator. For the self-employed, every day involves having to be good at a dozen jobs at once.
And when you can make it work, running your own business will take money. That's where credit lines come in.
Note, this article will discuss business lines of credit in the context of small business. While businesses of all sizes share the same basic principles, in practice large companies often experience lending differently from small ones.
What Is a Business Line of Credit?
A business line of credit is an unsecured lending option available to qualifying small businesses.
Like a lump sum loan (otherwise known as an installment loan), a line of credit provides the business with access to a specified amount of money under fixed lending terms. However, unlike a loan, the money is not provided up front. Instead the business can access funds up to this amount on an as-needed basis. Typically, a business has immediate access to this cash once the line of credit has been approved.
Unlike a loan, banks rarely, if ever, attach conditions for how a line of credit can be spent. This makes many lines of credit unsecured, since they are not attached to any specific purchase that the bank can use as collateral. However, a line of credit is not always unsecured. In cases such as a home equity line the borrower can stake collateral against the line of credit, although that collateral has nothing to do with how the borrower spends this money.
Once the business borrows any amount from their line of credit the bank begins to charge interest. This is typically calculated on a monthly basis.
A line of credit works on what is called a "revolving basis." This means that once the business repays some of its loan, that money becomes available to borrow again. A line of credit works more like a credit card than a lump-sum loan. The business can borrow from the same pool of money over and over again as long as it never exceeds the total lending cap.
Example of a Business Line of Credit
Richard has a flower shop. Like all flower shops, his is a business with peaks and valleys. His business thrives around specific holidays such as Valentine's Day, Mother's Day and wedding season, and it has long, stagnant periods in between.
To smooth his cash flow, Richard has a $10,000 line of credit with his local bank. In October he borrowed $4,000 from this line of credit, reducing his available lending to $6,000. In November and December, with holiday income, he paid this loan and the interest it had accumulated. By the beginning of the new year he once again had full access to the $10,000 line of credit for the long, flowerless slump of March.
Why Get a Business Line of Credit?
There are two main reasons why a business would take out a line of credit.
First, to meet specific, short-term needs. While a business completes a specific project it may face unanticipated expenses. A common example is construction and capital improvements. If, from our example above, Richard chooses to build an addition onto his flower shop, he might secure a line of credit for unanticipated expenses that arise while finishing construction.
Second, to smooth cash flow. This is the example used above. Many businesses with inconsistent or seasonal customers will use a line of credit to smooth their cash flow, ensuring that they always have access to a minimum amount of cash on hand.
Importantly, a line of credit is generally not an option for businesses just starting up. Rarely, if ever, will a business use a line of credit to pay for its initial launch.
How Does It Compare to Other Options?
A line of credit is typically one of the three main lending options available to a small business. The other two are lump-sum loans and credit cards.
Business Line of Credit vs. Lump-Sum Loans
Compared to a lump-sum loan, a line of credit typically offers more flexibility but less access to capital.
A line of credit offers immediate, rotating access to cash. Further, it lets a business borrow only up to its current needs, minimizing interest payments at any one time.
However, because this is an unsecured, flexible loan most (if not all) banks will lend less money than they would through a lump sum loan. Further, a line of credit will almost always be more expensive. As a result, for large capital needs you should generally consider lump sum loans. They are cheaper and easier to secure in the quantities you need. If you need access to cash on a periodic or ongoing basis, consider a line of credit.
Business Line of Credit vs. Credit Cards
A credit card and a line of credit function in virtually identical ways. Both are revolving loans in which you only pay what you actually borrow, when you borrow it. Both have a maximum lending cap, and you can borrow as much as you need at any time as long as you have less in total debt than this maximum.
The key differences are in volume and utility.
A line of credit typically has a higher (potentially much higher) limit than a credit card but is less convenient to access. As a result, a business will generally use its line of credit for major operational expenses while reserving the credit card for incidental expenses. For example, in our flower shop case, Richard might use his business credit card to pay for taxi rides to and from client meetings, while he would use his line of credit to pay for a new shipment of flowers.
This lower spending is generally wise, too, since a credit card will almost always charge higher interest rates than a line of credit.
How Do You Get a Business Line of Credit?
Most banks that deal in small business lending will also offer lines of credit. However do not expect to secure this form of lending right out of the gate. Banks tend to require good credit histories and a history of successful operations before they will offer a line of credit to a business.
The best place to begin exploring these options is with your local bank. Look up their options for business lines of credit or call to schedule an appointment and discuss this issue. As a way to access cash with minimal hassle, this is often an excellent option for small-business owners.
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