Revolving Credit for Business: The Step-by-Step Guide to Getting the Best
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Small business owners face two common problems. First, they need capital to grow. Second, small and new businesses typically have insufficient revenue to provide that capital. Revolving credit can provide a financial boost when it’s needed the most.
Sources of revolving credit vary from traditional bank loans and business credit cards to merchant cash advances. This article will explain the different types of revolving credit, how to decide which one is best for you, and how to successfully apply for them.
How revolving credit works
A revolving credit facility provides funding that a business can tap into at any time. The borrower pays interest only on the amount withdrawn and, once that amount has been repaid, the available funds return to the original amount. Hence the term “revolving” credit.
For example, say a business uses a credit card with a $10,000 limit, including expenditures, fees and interest, to purchase new equipment for $6,000. With the additional income that the new equipment provides, the business repays the $6,000 within three months. Then, the business once again has an available fund of $10,000.
Businesses owners should be aware of the pros and cons of using revolving lines of credit.
1. Access to capital
The number one reason why businesses fail is lack of capital, said Angela Dorsey, a certified financial planner for Dorsey Wealth. “Typically, people don’t have a huge pot of money to fund their business,” she said. “Even if they do, they still want to make sure that the business won’t be a financial drain on their family. Used strategically, revolving credit can help.”
2. Flexible funds
No business owner can predict an emergency, such as a crucial piece of machinery breaking down, for example. A revolving line of credit provides access to funds when they are most needed and without the delay involved in completing an application.
3. Tax deductions
A revolving line of credit can be beneficial in terms of taxes. Leon LaBrecque, a lawyer, certified public accountant and certified financial planner, drew attention to new tax laws that will affect small businesses this coming tax year. For example, if a business has less than $25 million in revenue, it can fully deduct its interest on any loans including revolving credit.
There are also changes concerning business owners who may decide to use a home equity loan to finance a business. According to LaBrecque, for any home equity loans taken out in 2018 or beyond, the interest is only deductible if it’s used for a home improvement. It’s not deductible if used for other purposes such as a business.
LaBrecque urges small business owners to consult with a tax expert such as a CPA. “The new tax law has some things that have never been around before,” he said. An expert can reorganize your business and personal debt to take advantage of tax deductions.
1. Minimum draw requirements or inactivity fees
Lenders want to make money too. Some lenders may require the borrower to use a certain amount of credit so that they can charge the interest on the amount used. For example, credit terms may include a percentage amount for minimum withdrawal in the initial period of a new account.
Similarly, a lender might charge an inactivity fee. For example, there may be a fee if there has been no withdrawal from the account for one year. A lender might also charge an amount for each withdrawal to incentivize the borrower to withdraw larger chunks of money at a time.
2. Limited capital
Regular small business loans offer funding into the millions of dollars, but revolving credit is often maxed out in the thousands. This is particularly the case if it is unsecured, meaning that there is no collateral backing the loan in the event of default. Secured credit lines provide larger amounts of funding, but the qualification requirements are more strict.
3. Temptation to rack up debt
A small business should have a business plan that lays out how a line of credit will be used and paid back. According to Dorsey, it can be tempting to rely on revolving credit as a crutch rather than as a temporary boost in capital to bring in revenue.
“Credit gets out of control; then you’re drowning in debt,” Dorsey said. “I’ve seen clients rely on it too much because sometimes lines of credit can be pretty generous if you have good credit.”
4. Intrusive lenders
If revolving credit is obtained from a bank, the bank might want close involvement with your business decisions. According to Kevin Reardon, a certified financial planner, “Once you start using the line of credit, the bank becomes your business ‘partner.’ They will want to look at your books and records, and can and may start challenging your decisions.”
Different types of revolving credit
Different types of revolving credit are differentiated by their interest rates, fees, repayment periods and qualification requirements. Which type is right for your business often depends on past business performance, the amount of capital that you need and your relationship with a lender. Here are the more common types of revolving credit.
Traditional bank lines of credit
Banks typically offer the best business line of credit terms, but, in turn, they have strict qualification standards and longer approval processes. If a business owner already has an established relationship with a bank, or if the bank knows your business and sees a viable and successful operation, you may be able to secure a line of credit with a favorable interest rate and terms. Bank lines of credit tend to be open-ended with just the need for a periodic review of business finances, often every five years.
Business credit cards
Business credit cards are perhaps the most popular revolving credit products. Data from Statista shows that leading credit card companies expect significant increases in spending by users, a 150 percent increase from 2015 to 2020 in the case of Visa.
Merchant cash advances
Merchant cash advances are increasingly marketed to small business owners, but they are largely unregulated and may have rocketing interest rates.
“Merchant cash advances are an exploding space today,” said Matt Chancey, a certified financial planner. “These providers look at the receivables, the tax returns for the business for the past couple of years, and they look at the merchant card processing statements for the past six to 12 months. If they can see, say, $50,000 a month in merchant processing, they know that there’s consistent cash flow coming through to the business, and they can take their payments back out.”
Chancey warns small businesses to be aware that these loans often come at extremely high rates.
“There are some shady players because some of the companies can charge crazy rates,” he said. “The way they compound the interest means that customers aren’t necessarily aware that they’re paying 50 percent interest on a hundred grand loan.”
Using business credit cards as a revolving credit facility
Why are business credit cards so popular? Partly because they are so convenient for short-term financing; an application can be submitted to a card issuer immediately. In addition, business credit cards may offer rewards, and some offer 0% APR for an initial period. If your credit score is low, your business is young, or your annual revenue is subpar, a traditional line of credit could be out of reach. In this case, a business credit card can give you the capital you need at a lower interest rate.
Dorsey said that many business credit cards have a very high limit, which might mean that the card can provide enough temporary capital for a small business.
“Depending on your credit, you may get a pretty nice limit,” he said. “Then, after a year or so, if your business is on track and you’re making your payments, you can ask them to increase your credit just so that you have that buffer.”
Still a business credit card must be used strategically to avoid racking up debt that is difficult to repay.
“A budget is so critical,” Dorsey said. “You don’t want to start using that business credit card to take everyone out to lunch or to buy the latest and greatest technology.”
How to apply for revolving credit
Here are recommended steps to apply for the right type of revolving credit.
Step 1: Determine how much you need to borrow.
Determine how much capital you need and estimate how long it will take you to pay off what you spend. Remember that you will have monthly payments that will come out of your existing cash flow, which could cause you to take longer to pay off the loan.
“If you borrow $20,000 from a merchant processor and they take $500 a day off your receivables, that’s a drag on your cash flow. You may not make it to four months to see the see the benefits of taking the loan in the first place,” Chancey said.
According to Chancey, once you figure out how long you’ll need to pay back that debt, you can then pick the product that makes the most sense.
Step 2: Look at your qualifications as a borrower.
Will a lender consider you high-risk? For example, do you have a good personal credit score? If it is above 700, you might qualify for a bank line of credit. Are your business financials strong, and does your business have longevity? If so, you are a good candidate for a bank line of credit. Do you have a good relationship with your banker and an existing checking account? This is another factor in your favor.
Step 3: Select a product.
Choose revolving credit that will give you the flexibility and capital that you need at a cost you can afford. Check for fees and minimum draw requirements. Also look at how the interest rate is compounded.
Lastly, LaBrecque urges small business owners to apply for revolving credit now while the economy is doing well and loans are comparatively easy to get.
“Small business owners should get their credit lined up earlier rather than later. Under the presumption that we may have a recession coming, I would rather have my line of credit ready now as opposed to when times get bad,” LaBrecque said. “Start talking to your bankers now, and your CPA. Talk to them now while times are good.”