What is a small business line of credit?
It’s an arrangement between a lender and a small business borrower where the lender agrees to lend up to a certain amount to the business, and the business can “draw down” that line on demand. Typically, they’re also “revolving,” meaning that the borrower can draw it down, repay some or all of the drawn down amount, and draw it down again. In a nutshell, it’s like a credit card (but without the card).Pros and Cons of a Small Business Line of Credit
PROS
- Pay for Only What you Use. Setting aside the initial closing fees, you typically on pay interest on what you actually draw down. So with a $100,000 line of credit, if you only draw down $10,000, you only pay interest on $10,000. And then you stop paying interest when you’ve paid it back.
- Ease to Get. Because they’re smaller and have shorter terms, lines of credit tend to be easier to get. In a lot of ways, they’re a lot like a credit card, and they’re about as easy to get. All you need is a credit score a little revenue.
- Boost Your Business Credit Score. A small business line of credit improves your small business credit score in much the same way that a credit card improves your consumer credit score. It establishes another trade line with a payment history, and it increases your total borrowing limit, which lowers your utilization… provided you don’t over-utilize it!
- Great for a Rainy Day. Because you only pay for what you use (fees aside), you can get a line of credit in flush times and then only draw upon it when you need it. This provides a nice working capital cushion for lean times or rainy day needs… and it’s typically much cheaper than a merchant cash advance!
CONS
- Fees. Small business lines of credit typically come with upfront setup fees, annual fees, etc., similar to a credit card. Your lender has to make their money somehow!
- Higher Rates. Small business lines of credit tend to have higher rates than term loans. So if you’re planning on keeping it fully or mostly drawn, you’ll be paying more in financing and interest fees than you’d pay with a comparable term loan.
- Covenants. Small business lines of credit are strange in that the lender will underwrite you at your strongest, and then you’ll typically draw down at your weakest. This makes pricing the risk hard. The way most lenders get around this is to impose covenants (e.g., “Keep your debt service coverage ratio above 1.15”) and require frequently (typically monthly) certifications. If you don’t comply with these covenants, expect the flow of money to dry up.
- Revocation. Over and above the covenant requirements, lenders typically have the ability to revoke a small business line of credit on short notice. Many banks, for instance, did this during the 2008 Financial Crisis, and this can cause an operational crisis for your business when working capital you’ve been depending on suddenly dries up.
- Shorter Term. Business lines of credit, like credit cards, are typically short-term financing solutions. As a result, you typically need to pay them back over shorter terms than you would with a term loan for instance. If you can’t for some reason, the bank will often terminate the line and ”term out” the line of credit by turning it into a term loan.
Best Uses
Small business lines of credit are best used for short-term working capital and cash flow management. They’re also good to have in reserve to use in emergencies, as an alternative to a merchant cash advance.Summary
A small business line of credit is like a heavy-duty credit card. You can typically draw it down on demand, repay it, and then draw it down again. You only pay for what you use, which makes it a strong short-term working capital solution. But due to the rates and terms, they’re typically not well suited for financing longer-term projects.
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