How Does a Line of Credit Work for a Business?

A business line of credit offers a flexible financial tool for companies to manage working capital and unexpected expenses. Unlike a traditional term loan that provides a lump sum, a line of credit allows businesses to access funds as needed, up to a predetermined limit. This adaptability makes it suitable for addressing fluctuating cash flow, covering short-term operational costs, or seizing immediate growth opportunities. It functions similarly to a credit card, where interest accrues only on the amount drawn, providing a cost-effective solution for businesses seeking on-demand liquidity.

What a Business Line of Credit Is

A business line of credit is a revolving credit facility. This means a company can borrow, repay, and then re-borrow funds repeatedly up to a set credit limit. As repayments are made, the available credit replenishes, allowing for continuous access to capital without reapplication for each draw. This structure provides businesses with ongoing financial flexibility, particularly useful for managing variable expenses or seasonal demands.

The credit limit represents the maximum amount of funds a business can access. Interest rates on business lines of credit are variable, fluctuating based on market conditions, and are often tied to a benchmark rate like the Prime Rate. Businesses only pay interest on the specific amount drawn from the line, not on the entire approved credit limit.

Draw periods specify the timeframe during which a business can access funds, commonly ranging from one to five years. Following the draw period, a repayment period begins, during which any outstanding balance must be paid off. Repayment terms outline how the borrowed principal and accrued interest will be paid back, often through minimum monthly payments.

Business lines of credit can be either secured or unsecured. A secured line of credit requires collateral, such as accounts receivable, inventory, equipment, or real estate, which the lender can claim if the business defaults. Providing collateral allows businesses to qualify for higher credit limits, lower interest rates, and more favorable terms due to reduced risk for the lender. Unsecured lines of credit do not require specific collateral but necessitate a strong credit history and financial standing, often coming with lower credit limits and higher interest rates.

How to Apply for a Business Line of Credit

Applying for a business line of credit requires submission of financial and operational information to the lender. Businesses need to provide a detailed business plan outlining operations, market analysis, and financial projections. Lenders assess these documents to understand the business’s viability and its capacity for repayment.

Key financial statements are required, including balance sheets, income statements, and cash flow statements, for the past two to three years. These statements offer insights into the company’s financial health, historical performance, and liquidity. Lenders request business tax returns, such as IRS Form 1120 for corporations or Schedule C for sole proprietorships, and personal tax returns for all principal owners or guarantors to evaluate overall financial stability.

Bank statements for the most recent three to twelve months are necessary to demonstrate consistent cash flow and transaction history. Lenders examine both personal and business credit scores, as these scores reflect a borrower’s creditworthiness and payment history. A personal FICO score of 660 or higher is preferred, with some lenders accepting scores in the low 600s, especially if collateral is provided.

Eligibility criteria vary among lenders but include factors such as time in business, annual revenue, and profitability. Traditional banks often prefer businesses to have been operating for at least two years, while some online lenders may consider businesses with as little as six to twelve months of operation. Minimum annual revenue requirements can range from $10,000 per month to $250,000 or more annually, depending on the lender and the requested credit limit. The application process involves an initial inquiry, submission of all required documentation, and a review period by the lender, which can range from a few minutes for online applications to several weeks for traditional banks.

Using and Repaying Your Business Line of Credit

Once a business line of credit is approved, accessing funds is straightforward. Funds can be drawn through various methods, including online transfers directly to a business checking account, issuing checks against the line of credit, or direct debit arrangements. This flexibility allows businesses to take only the amount of funds they need at a specific time, avoiding unnecessary interest accrual on unused capital.

Repayment mechanics involve understanding how interest is calculated and minimum payment requirements. Interest is charged only on the outstanding balance, meaning the amount of funds actually utilized, not the entire credit limit. Minimum payments are required monthly and consist of accrued interest plus a percentage of the principal balance, or a fixed minimum amount, whichever is greater. Some lines of credit may offer interest-only payment periods, followed by payments that include both principal and interest.

Understanding the specific terms and conditions of the line of credit agreement is important. This includes knowing any associated fees, such as annual fees for maintaining the line, which can range from $50 to $750 or more, or draw fees charged each time funds are accessed, up to 2% of the withdrawn amount. Inactivity fees might also apply if the line remains unused for an extended period.

Covenants, which are conditions or restrictions imposed by the lender, are part of the agreement. These can include financial reporting requirements, such as submitting updated financial statements periodically, or maintaining specific financial ratios, like a certain debt-to-equity ratio. Adhering to these terms ensures the business remains in good standing with the lender and maintains access to its credit facility. Responsible usage, including timely repayments and adherence to covenants, contributes positively to a business’s credit history.