How does a business line of credit work?

A business line of credit is a type of business financing that works a lot like a business credit card. It gives your business access to a specific amount of funds, called a credit limit, which it can withdraw from as needed. Usually these range from $1,000 to $250,000.

Typically it takes between a few hours and a few days for a withdrawal to appear in your business bank account. In some cases, each withdrawal turns into a short-term loan, which you repay plus interest and fees. In others, the lender requires your business to make a minimum monthly payment on the balance similar to the way you pay off a credit card.

Most business credit lines are revolving, meaning that as you pay off your withdrawal, the balance replenishes. But in a few cases, lenders offer nonrevolving lines of credit. These can’t be used again after they’re paid off.

Secured vs. Unsecured Business lines of credit

Often, your business will have a choice between a secured line of credit and an unsecured line of credit.

A secured line of credit is backed by your business’s assets often inventory, accounts receivable, or a general lien on business assets. This means if you default on your line of credit, the lender can seize the collateral to make up for the loss.

An unsecured line of credit does not require collateral. However, many still require a personal guarantee from all small business owners with a 20% stake or more in the company which is also a requirement for most secured credit lines. This means that the owners are responsible for paying the line of credit if the business can’t.

A secured line of credit often comes with lower rates and fees than an unsecured line of credit. And backing your credit line with collateral can help you qualify for a higher credit limit. However, unsecured credit lines often have a quicker turnaround time when you first apply.

Pros and cons

Lines of credit can be highly beneficial to small businesses, there are some highlights and drawbacks worth noting before you sign up.

Pros

* A business line of credit gives you a safety net for unexpected costs, helping you avoid expensive short-term loans. You only pay interest on what you use, rather than taking out a larger term loan more than you need and paying more interest than necessary.

* You can often qualify for lower rates and fees than a credit card. This can help you save on regular expenses that add up in the long run, like office supplies. It gives you access to cash, not credit. Cash is often required for costs like payroll, hiring contractors, and paying rent or utilities. It can help you develop a long-term relationship with a lender, which can lead to lower rates and loyalty discounts down the road.

Cons

* Credit limits are often lower than term loans, making it less-than-ideal for a large, one-time expense.

* Minimum withdrawal requirements can force your business to borrow more than it needs. These are particularly common during the first six months your small business has a credit line.

* Business lines of credit come with more fees than a term loan. This can make them appear less expensive than they actually are if the lender only advertises the interest rate.

* Variable interest rates are more common with lines of credit. These typically increase when the economy is doing well and decrease during a downswing.