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Small Business

How Does a Small Business Line of Credit Work?

min read

As a small business owner, you have many responsibilities to juggle.

You can either choose to handle all the daily tasks yourself or pull together a team to help tackle sales, marketing and bookkeeping, among other duties. Regardless of whether you have employees or not, the path to long-term profitability is both a rewarding and a challenging one. Before all else, you’ll need to be sure you have the adequate cash flow to meet obligations like rent payments, office expenses, and possibly payroll.

You can certainly use cash to finance operations but revenue streams can sometimes be tough to predict. To eliminate a drain on savings, entrepreneurs typically use debt to make certain they have enough resources to keep the business rolling along when sales track up or down. Traditional loans are one way to help cash flow but many owners ask how to get a business line of credit (BLOC) because of the flexibility it offers.

What Is a Business Line of Credit?

A business line of credit gives you the ability to tap cash whenever you need it.

A lending institution will assess your creditworthiness and the financials of your business to determine if you qualify, and what size line will be offered. Like most other debt offerings, a BLOC’s interest rate and credit limit will be pegged to factors like your credit history, years in business, past cash flow, and future revenue projections.

A BLOC differs from a traditional loan in one major way: You never have to use it, and you can treat the line like an emergency fund. For instance, if a bank deems you worthy of securing a $50,000 BLOC,  you can draw off the established line at any time—  up to that maximum limit. You’re not required to make any principal and interest payments until you actually tap the funds from the line.

A regular business loan involves taking physical receipt of the money, and the repayment period usually begins in the next 30 days or so. Unlike a BLOC, which has no fixed term, the term of a loan may require you to pay off the obligation in 3 years, 5 years or 10 years, for instance.

How Does It Work?

Once you’ve assessed how to get a small business line of credit, it works exactly like a credit card.

You can use checks or a card to make purchases or pay bills, and from that point on, principal or interest payments become your responsibility. You can choose to make monthly minimum payments that will be set by the lender based on what you use or choose to pay off the entire balance. You don’t have to worry about prepayment penalties because the line is designed to stay in place for the long-term— perhaps 10 years at a minimum.

A small business line of credit usually doesn’t require you to put up any collateral. But, once amounts start to exceed a certain dollar level (maybe $100,000 or greater), you may have to pledge real property as security. This strategy is to protect the lender from a large financial loss in case the borrower can’t repay the debt.

How Do You Qualify?

Like any other borrowing process, a lender will want to take an application and review your financial track record before it decides how large of a line you are eligible for.

The stronger your cash flow and credit score, the larger the dollar amount of the line that will be extended. Quite often, your interest rate will be correlated to the strength of your financial standing. Some brand new businesses might be required to wait a bit before they’re able to gain approval for an unsecured business line of credit.

Depending on the lender’s rules, fledgling businesses may have to be operational for six months to a year before qualifying for a line. This is so a bank can get a better feel for the performance of a business and the potential for small business growth before it commits to offering the funds.

What Else Should You Consider?

You should always be aware of the interest rate environment before securing a BLOC— especially with regard to how the rate within the line is structured.

Most often, the life of the line is 10 years, and you can expect to see business line of credit rates rise and fall in that time frame.  As such, most lenders offer variable interest rates to compensate for the rate of fluctuations that inevitably occur in a decade’s time. Be sure you understand how fluctuations in small business line of credit rates could affect your principal and interest payments.

How Much Should I Accept?

The amount of credit you select does not have to equal the maximum figure initially offered by your lender.

You can always choose a lower amount and ratchet it up as you seek more space or hire more employees. One important guideline is that no matter what amount you accept, be sure you have the means to pay it back. You should have room for debt service in your revenue and cash flow projections, so don’t exceed the monthly payments you have plugged in.

A good rule of thumb for a small business is to arrive at a simple debt-to-equity ratio when gauging the amount of debt to safely assume. Keep your debt level at 50% or less of the assets owned by the business. For example, if you have $50,000 in cash and/or equity, borrowing no more than $25,000 would be a prudent move.

How Can I Protect My Business?

In business, you should always plan for the unexpected.

And in at least one projection, plug a worst-case scenario in the mix. If you own inventory, office facilities or equipment, business insurance is a must for both new and established businesses. Not only will you need to protect your physical assets, but you’ll need liability insurance to shield you from legal action in the event of an accident on the premises or a faulty product.

Doing a complete small business risk assessment helps you manage the risk portion of your business plan, and makes sure that you can thrive and prosper through any circumstance. That might include a case in which a business income policy will help make principal and interest payments on a BLOC— even while you recover from damage to buildings or downtime on computer systems.

Final Thoughts

Using debt to help finance operations while building equity is an age-old strategy employed by companies of all sizes and shapes.

If you follow common-sense practices when using a BLOC to start up or expand operations, there’s no need to shy away from debt financing as a way to grow your business.

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