Finances

Line of credit for business: everything you need to know

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This guide outlines what you need to know about a line of credit for business, including secured vs unsecured.

A line of credit is an excellent financing tool for many small businesses. It is a way for you to get immediate access to capital which can be used when needed and repaid over time. In other words, a line of credit is a loan.

However, there are a few things you should know because a business line of credit is different from your standard business loan.

Recommended reading: A simple guide to business loans and finance by Westpac Bank’.

Line of credit options: Secured vs unsecured

Generally speaking, there are two types of line of credit: secured and unsecured.

You’ll notice that this is similar to other types of financing where a secured business line of credit requires you to pledge collateral that the lender can seize if you fail to repay what you borrow. On the other hand, an unsecured line of credit does not require collateral (click here to learn more), however, you as an individual will become personally responsible for any outstanding debts.

Depending on your circumstances, a secured or unsecured line of credit may be more appropriate to your personal situation. Always seek the advice of a qualified financial advisor to better understand the implications of taking out either a secured or unsecured line of credit for your business.

You will not get a lump sum payment

Unlike a credit card or a typical business loan, a business line of credit does not give you immediate access to a lump sum payment. For example, for many business loan types, once approved, you will have access to the full amount upfront. Instead, by definition, a line of credit provides you with a credit limit that you can borrow against in the future.

Some lenders refer to this mechanism as the “draw period” where you will “draw down funds” when you need it and repay the amount borrowed, inclusive of interest.

This feature is perhaps what makes a line of credit different from other financing options and this may or may not be what you need to achieve growth or to cover uneven periods of cash flow.

How is interest calculated?

Unlike a business loan where you have to make a monthly repayment, with a small business line of credit you are only responsible for paying back what you have drawn down instead of the entire credit limit.

That is, interest is charged only on the amount you have borrowed. Furthermore, interest rates tend to be variable instead of being a fixed rate for lines of credit.

For example, let’s say you have been approved with a small business line of credit of $40,000. When you draw down $12,750 to help cover payroll and operational expenses, interest is charged on the $12,750 amount, not the overall $40,000. However, the repayment may vary depending on the variable interest rate.

What’s the difference between a line of credit and a business credit card?

A line of credit gives you access to an amount that is often more than a business credit card but less than what you can get from a loan term.

Almost all business credit cards issued by major financial institutions are unsecured. This differs from business lines of credit as the lender can offer both secured and unsecured options. This means that if you choose to offer up collateral, you may receive a more favorable interest rate and get access to a higher credit limit.

Some lines of credit will also come with an establishment and monthly account keeping fees although some lenders may waive these to attract your business.

When should you consider one over the other?

There are instances where you may want a lump sum upfront payment for a specific purpose. Perhaps you need to acquire machinery that costs north of $75,000. Most lenders have specific business loans for equipment purchases and it will make more sense to explore these business loan options instead of a business line of credit.

Explore these other financing options for your business:

Evaluation before applying for credit

Before taking the first step, it is recommended to evaluate the pros and cons. Therefore, the first thing is to ask yourself if there really is a need for financing. Developing a business plan can help find the answer. This is the document that will organize the information so that you know whether or not you will make the decision to apply for the investment.

This business plan should include the values of fixed investments and working capital, what results arise, what is the origin and application of resources. Still, it is clear that, no matter how good the business plan is, it does not guarantee the release of resources by the financial agent.

What is the required amount?

But how to know exactly the amount? For this it is necessary to define the amount of resources that the company effectively needs, and for this it is essential to detail the machines, equipment, vehicles, furniture and utensils in which it will invest and what their respective prices are.

How can I make the payment?

Study your cash flow well and check if there are enough resources to amortize the debt to be contracted. It is also necessary to verify if the financing expands your business and increases its profitability, in order to cover the amortization of the installments of the loan.

Self-financing is one of the ways to leverage resources for business activity. Therefore, negotiate longer terms with suppliers and reinvest the profit of the business instead of withdrawing it

Identify the best financing

Check the credit possibilities, as this is a decisive factor for planned financing, which does not negatively impact the financial routine of the company.

Therefore, researching existing financing alternatives and which ones fit the needs of the business is fundamental. Look at your relationship with your bank and learn about the financing possibilities or search the financial market for the offers that will best serve you in the short, medium and long term.

Summary

If you do not require a lump sum upfront, a line of credit may be something you may wish to consider, especially as a short-term ‘borrow-what-you-need-when-you-need-it’ type of solution. However, this flexibility will come at the expense of higher interest rates and you may find that the borrowing limit of a line of credit to be significantly lower than of a business loan.

To find out more, speak to your lender or financial advisor to get tailored financial advice.

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