Start Up Business Line of Credit: Is It Right for Your Business?
Getting financing, particularly from banks and institutional lenders, can be tough for new businesses. That’s because new business owners often don’t have the documentation to show that their business can afford to pay back a debt. But it’s not impossible for a startup business to get financing, particularly with a strong personal credit history or solid business cash flow.
A start up business line of credit might be a good option for a business that’s just gearing up, said credit expert Gerri Detweiler, educator director at Nav, a company that helps business owners access funding and make informed financial decisions. It has the flexibility of a business credit card, but a bit less risk than a term loan because you only pay for what you borrow. If you don’t draw any money from the line, you don’t have any payments to make.
It also never hurts to have funding in place in case a business owner needs to make an unexpected purchase or pay for an emergency expense. “It’s always easier to borrow money when you don’t need it than when you do,” Detweiler said.
Understanding a start up business line of credit
In many ways, a small business line of credit is not so different from a business credit card. A lender sets your spending limit and you only pay interest on what you borrow. They’re also revolving, so when you pay back a portion of what you’ve borrowed, your available credit grows by that amount. Lines of credit, though, give you access to cash rather than credit and typically come with lower interest rates than credit cards.
Most small business lines of credit fall in the $10,000 to $100,000 range, although they can go as low as $5,000 and as high as $1 million. The lender will set how much you can borrow, how long the line of credit lasts before it needs to be renewed and how much interest you pay.
Most lines of credit have variable interest rates based on the prime rate plus a certain amount. Large lending institutions generally charge an additional 1% to 5% more. Unlike small business loans, you don’t get a lump sum amount of money upfront and you don’t need to make payments of interest and principal from the start.
To qualify for a business line of credit from traditional lenders, you’ll probably need to have the following:
- Been in business for two years
- Revenue of at least $100,000
- Personal credit score of 680 to 720, according to Detweiler
Solid credit history and good collateral options also help even if the loan is unsecured. That’s why it can be tough for new businesses to get a line of credit from a bank.
Younger businesses can check out lines of credit backed by the Small Business Administration (SBA) and provided by banks because they don’t have a minimum number of years in business. But they are still difficult to qualify for because if too many borrowers default on SBA loans, the banks can lose the right to offer them, Detweiler said.
Businesses that have been open less than a year or two might consider online lenders for a line of credit. These lenders often have looser requirements and faster approval, but they typically offer higher interest rates and smaller credit lines.
Pros and cons of business line of credit
No loan is perfect, but knowing the advantages and disadvantages that come with a business line of credit can help you decide if it’s right for you.
Draw when needed. An already-secured credit line can give a business owner a chance to weather an emergency or jump on an opportunity that requires fast cash. You also only have to pay for what you borrow versus a loan that has a set repayment schedule.
Manage cash flow. If your business is seasonal, a credit line can help even out cash flow so you can pay expenses during the leaner times. It can also be a good source of funding to purchase inventory before you get the revenue from the sale of that inventory. For example, if you sell hats and one type is extremely popular, you could use a line of credit to make the large purchase. You could use the sale of each new hat to pay back what you borrowed.
Build credit. Managing your credit line responsibly now helps to build credit history for when your business may need a loan in the future, maybe for a larger expense like a real estate or major equipment purchase.
Stricter requirements for new businesses. A new business might find it very tough to get a line of credit from a bank. That’s because most banks want a business to have been in operation for two years, have $100,000 in yearly revenue and for the owner to have a personal credit score of at least 680, Detweiler said.
Variable interest rate. Unlike many term loans, most lines of credit have variable interest rates. That means your interest rate could increase, making it more expensive to borrow. The lender can also raise your rate if you miss a payment.
Risk. Debt is debt. While handling debt responsibly over time helps your credit history, you still have a financial obligation to repay if you borrow from the line of credit. You’re also still on the hook to pay back what you borrowed even if your business fails because of the line’s personal guarantee.
How they stack up
When does it make sense to pursue a line of credit versus a different type of loan? Here is how a line of credit compares to two common loan types: a business credit card and a business term loan.
Line of credit versus a business credit card
These two share some similarities such as capped borrowing amount and only paying interest on what you draw. But there are key differences:
Better for smaller expenses for newer businesses
|Line of credit vs. business credit card|
|Line of credit||Business credit card|
|Better for larger ongoing expenses for more established businesses||Better for smaller expenses for newer businesses|
|Harder for startup businesses to qualify for, but easier than a loan||Qualifying is easier because income is based on business, personal and spouse income|
|Lower interest rates||Higher interest rates|
|Higher spending amount||Cash advances are expensive|
|Access to cash||High late fees|
|Sometimes secured by collateral||Ability to earn rewards|
Line of credit versus term loan
Term loans are another alternative to a line of credit. Here’s how they compare to each other.
|Line of credit vs. term loan|
|Line of credit||Term loan|
|Repay only the amount you borrow||Set repayment schedule|
|Credit available again after you repay||Option to refinance|
|Funds can be used for many purposes||Funds used for specific purpose|
|Variable interest rate that can change||Generally, fixed interest rates|
|Amount you can borrow might be less||One-time lump sum; must apply again to get more funds|
Is a business line of credit right for you?
If your business has seasonal ups and downs or you need to cover short-term expenses, a business line of credit might be a good fit. Aside from fees, they don’t cost you until you tap the money.
Covering cash flow gaps. If your business has slow months or even whole seasons, a business line of credit can help you cover expenses such as taxes, payroll, rent or mortgage payments that still must be paid even when business slows down.
Short-term expenses. If you don’t have a lot of cash on hand, a line of credit may be a good solution if you need to purchase inventory or manufacture goods, but won’t be able to pay for the inventory until you start selling it.
Who/what type of business should avoid a business line of credit
If you need a smaller amount of money to fund everyday expenses, a business credit card might be a better option, Detweiler said. A credit card will also help you build credit history if you need a loan later. If your business is brand new and you don’t have good credit history, cash flow or collateral, you might also want to consider other funding options.
If you need cash fast, then it’s not a good idea to look at a business line of credit from a bank, which can take weeks to months to approve. “If you need to jump on an opportunity quickly, then it’s not ideal for your business,” Detweiler said.
Shopping for a business line of credit
You should always shop around when looking for financing. Consider both traditional lenders and online lenders to see who would likely approve you for a loan and at what cost. Know the following details to appropriately compare offers:
- Interest rate and how it might change
- How to renew the line of credit
- What happens if you default
- Is it secured or unsecured?
- General requirements are for approval
Unlike with consumer loans, steep interest rates don’t always have to knock a lender out of contention, Detweiler said. Borrowing at 50% with a personal loan doesn’t make sense, she said. But a business loan at 150% could. “If there’s room to pay interest and still make a good profit, then you might want to go for it,” she said.
Here is a closer look at some of the main considerations when you’re shopping around for a business line of credit:
Interest rates. Most traditional lenders will charge an interest rate that is the prime rate plus a certain number of percentage points, which might range from 1% to 6% depending on a number of factors. Online lenders typically charge higher interest rates, but have less stringent approval requirements and can qualify your business faster. Line of credit rates are variable, so the amount you pay on what you borrow can change depending on the prime rate. If you miss a payment, your rate could jump as well.
Fees. Almost every loan comes with fees. It’s important to know the fees so you know exactly how much the loan will cost you even if you don’t withdraw anything. For business lines of credit, some common fees include:
- Origination fee: This covers the cost of processing the loan.
- Maintenance fee: This is an annual, or sometimes monthly, charge to keep the credit line open.
- Renewal fee: This fee is charged if you renew the line after a certain point.
- Draw fee: A percent-based charge incurred each time you withdraw from the line of credit. (For example, a 2% charge every time you make a withdrawal from the line of credit).
Maximum amount. In her experience working with business owners, Detweiler has found that they don’t always know how much money they need and what they need it for when applying for a loan. While you can pay back an amount you borrowed and pull again from a line of credit, it’s
Harder to increase the credit line. So, make sure you know how much you’re allowed to borrow and whether that’s enough to meet your needs.
Unsecured vs. secured. Most lines of credit are unsecured, meaning they’re not tied to collateral–such as real estate, inventory, certificates of deposit, among other items–to secure the loan in case you default. But most lenders will require a personal guarantee, which allows them to sue you for your personal assets to repay the loan if you fail to repay.
“Even if you don’t have physical collateral, the lender can still take an interest in the revenue of your business,” said Detweiler. Lenders can file a UCC-1 statement, allowing them to “have first dibs on the assets of a business” if you don’t make payments, Detweiler said.
Many lenders require larger lines of credit to be secured. Collateral could be a blanket lien on your assets, a certificate of deposit, personal or business assets or a combination of both. Secured lines of credit usually have lower interest rates.
Applying for a start up business line of credit
The process of applying for a start up business line of credit depends on the type of lender. Most banks require you to apply in person at a bank branch. Some banks and credit unions allow for online applications, in particular for smaller loans. Online lenders typically provide a short initial online form to get the process started. A follow-up call from a funding specialist typically comes next.
To be considered for a bank business line of credit loan, you’ll need to meet some basic requirements.
- Been in business for two years, but at minimum one year
- Minimum of $100,000 in annual revenue
- Minimum credit score of 680
Some lenders will also look at your FICO Liquid Credit Score, which is a combination of your business and personal credit history, your business financial information and other factors like the size and industry of your business. The approval process can take weeks and sometimes months.
The most common documents you’ll need are:
- Personal and business tax returns
- Bank account information
- Business financial statements
- Profit and loss statements
- A balance sheet
Online lenders generally have more relaxed standards for approving loan applicants. These are some general standards and could be even looser, depending on the lender.
- Just six months of business operation
- Minimum of $50,000 in annual revenue
- Credit score minimum of 500 to 600
Approval in some cases can occur in mere hours, although 24 hours is common. Time to funding can be as little as one to two days. You generally must fill out far less paperwork and provide less documentation than with a bank. Typically, online lenders will want to see three months worth of business bank statements and know your gross business revenue for a set time.
How much will a business line of credit cost?
How much you end up paying for a line of credit will depend on a many factors. Because most traditional lenders don’t offer startup business lines of credit, you may need to get the loan from an online lender. Interest rates for online lenders are almost always higher because they will work with riskier borrowers and their loans are usually smaller, so they’ll want to recoup the cost of underwriting the loan. The better your credit history, business revenue and assets, the lower your interest rate will be.
Then there are the fees such as an origination, maintenance, renewal fee and withdrawal fee. The fees tend to increase as your credit line increases. Origination fees and maintenance or annual fees generally range from $100 to $250 apiece.
And finally, there’s interest. You won’t pay interest unless you draw from the line of credit, but once you do, you’ll be charged interest on any outstanding balances. Most interest payments are based on the average balance multiplied by the interest rate.
If your business has been in operation for less than a year, a business line of credit might be tough for you to get, especially from a bank or other traditional financial institution. So you might need to consider online lenders with higher interest rates. This may work fo you if you have the cash flow to cover the expense of withdrawing from the line. A line of credit is useful for businesses who might need a little coverage in cash flow now and again or the ability to tap into quick cash. For smaller, everyday purchases, a business credit card might be a better way to go.