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Payday is coming up, but your biggest client hasn't paid their invoice yet. As your business's bank account dwindles, you start to worry, "Will I be able to make payroll next week?" Uneven cash flow is a problem for many small businesses, and a business line of credit could be the solution. A business line of credit is a type of business loan that functions more like a business credit card, allowing you to draw money when you need it and pay it back over time.
Businesses often use lines of credit to get them through a slow season, buy materials or inventory, or provide a financial cushion in case of emergencies. Read on to find out if it's the right move for your business.
How Does a Business Line of Credit Work?
Most business lines of credit are revolving credit. Kind of like a credit card, a revolving business credit line gives you a set credit limit up to which you can borrow. You can either carry the balance, making at least the minimum payment each month, or pay it off in full; interest accrues only on the amount you borrow.
As you pay back the funds you've borrowed, a revolving credit line lets you borrow more without having to apply for a new line of credit. There are, however, business credit lines that do not allow you to revolve debt; these require you to reapply after you've paid back what you borrowed.
Business lines of credit come in two basic flavors: secured and unsecured.
- Secured lines of credit require collateral. This might be business assets such as equipment, inventory or receivables, or personal assets such as your house. There are also secured lines of credit that require a personal guarantee or a lien on your business. If your company is new, with low sales and no established business credit score, a secured line of credit may be easier to get. Just be sure you don't pledge any collateral you don't want to lose.
- Unsecured lines of credit don't require collateral, but they usually require annual revenue, a higher business and personal credit score, and a longer business history. This evidence of success helps convince the lender that you'll be able to repay the money.
Even if your business can qualify for an unsecured line of credit, it may be to your advantage to apply for a secured line of credit. That's because unsecured credit lines tend to charge higher interest rates and offer lower credit limits.
You might be wondering why a business owner would get a line of credit rather than a loan. There are some key differences between a business loan and a business line of credit.
Whereas a line of credit is revolving credit, a business loan is installment credit. When your loan application is approved, you get a lump sum of money and must start making fixed monthly payments on it right away—even if the money is just sitting in your bank account. When you pay off the loan, the account is closed. If you want more money, you'll have to apply for a new loan. Business loans are often restricted to certain uses, such as buying equipment or real estate.
A business line of credit on the other hand can be used for whatever business purpose you want. Business credit lines are usually available for smaller amounts than loans, with about $250,000 being the maximum. Because banks are often reluctant to issue smaller loans, a line of credit can be easier to get.
Who Qualifies for a Business Line of Credit?
The documents required to apply for a business line of credit may vary slightly depending on the lender you're approaching and how much money you want. In general, though, you'll need to provide the following information:
- Personal and business tax returns: This helps provide proof of your business's revenues.
- Bank account information: Some online lenders ask you to provide access to your business bank accounts so they can verify your financial information.
- Business financial statements: Lenders want to see proof of your annual revenues and other sources of income to be sure you have the financial resources to pay back the line of credit.
- Basic personal identification information: Your Social Security number and identification.
- Basic business identification information: This might include your Employer Identification Number (EIN), business name, business entity type, business address, and business licenses or permits.
- Current debt schedule: If your business already has outstanding loans or other debt, lenders will want to see your monthly payment commitments.
What Credit Score Is Used for a Business Line of Credit?
Lenders generally consider a mix of your personal and business credit scores when considering your application for a business line of credit.
The three major business credit bureaus—Dun & Bradstreet, Experian and Equifax—gather information on your business from your vendors and suppliers, bankers and lenders, public records and other sources to build your business credit report.
The information in those reports is also used to create business credit scores. Three commonly used business credit scoring models are the Experian Intelliscore Plus, the D&B Paydex Score and the Small Business Scoring Service℠ (SBSS) FICO uses. Each business credit scoring model works a little differently and might be used for different purposes, such as to assess lending risk. The D&B Paydex Score and Experian Intelliscore Plus models use a range from 1 to 100, and SBSS scores range from 0 to 300. Generally, higher scores mean better credit; lower scores mean higher risk.
Your personal credit rating could also be a factor in your ability to get a business line of credit, especially if you're a sole proprietor or have a relatively new business without a business credit history. Before you start researching business lines of credit, check your personal credit report and score to see how your credit measures up.
Different lenders have different minimum credit score standards you'll have to meet to get a business line of credit. However, in most cases, you'll need a personal credit score of 580 or above, or at least "fair" in the FICO® Score☉ scoring model. If your credit score is on the lower end of the scale, you may pay more for a credit line and be asked for more collateral than if your credit score is good or excellent.
You can start building a business credit history by forming a corporation or limited liability company (LLC) to separate your business and personal identities, opening business bank accounts in your company's name, and asking your vendors and suppliers to report your payments to the three business credit bureaus. Getting a business credit card and paying your bills on time will also help to improve your business credit score; just make sure the credit card issuer reports to the business credit bureaus.
Where Can You Get a Business Line of Credit?
You can get business lines of credit from a variety of sources, including banks and online lenders and through the Small Business Administration (SBA). Here's a closer look at the pros and cons of each.
- Traditional banks: Banks typically have stricter lending requirements for lines of credit than online lenders do. For example, they are likely to require more documentation, expect to see higher credit scores and take longer to approve lines of credit. The tradeoff: Banks generally offer lower interest rates, better terms and larger credit limits. Your current business bank can be a good place to start investigating lines of credit; just be sure to shop around and see what other lenders are offering as well.
- Online lenders: There are plenty of places to apply for a business line of credit online. These include online lending marketplaces that match businesses with lenders and direct online lenders who make loans themselves. Both types of online lenders generally have a faster, simpler application process than banks. They may focus more on your cash flow than on financial statements, for example. They also tend to be more flexible than traditional banks in their approval criteria, so smaller, newer businesses that can't get credit lines from banks may want to try this option. Just keep in mind that online lenders generally charge higher interest rates than banks.
- The SBA: The SBA CAPLines program offers four types of credit lines: a seasonal line of credit, a working capital line of credit, a line of credit for builders and contractors, and a line of credit for subcontractors. You must meet the criteria for the SBA's 7(a) loan program to be considered for any of these credit lines. The SBA does not issue credit lines itself; instead, it works with approved lenders who do. The SBA guarantees a percentage of the credit line, making lenders more willing to extend credit to small businesses. Earning that guarantee isn't easy: This option is best for businesses with an established track record and the ability to provide solid documentation of their financial stability.
Using a Business Line of Credit to Grow Your Business
Checking your business credit report and personal credit score before you apply for a business line of credit can help you determine whether you're likely to be approved. The higher your scores, the better your chances of getting a credit line from lenders who have strict criteria, such as banks. If your scores are on the lower end of the scale, you may take some time to improve them, or try your luck with online lenders.
Getting a business line of credit, using it and paying it back on time can help a new business build a business credit score, which will make it easier to get other kinds of financing as your company grows. Just make sure that the lender reports your payments to the three major business credit bureaus: Dun & Bradstreet, Experian and Equifax. Using Experian's credit monitoring service Business Credit Advantage can help you stay on top of your business's credit history and credit score—two key factors in your business's financial future.