What Is a Small Business Line of Credit and How Does It Work?

inancing can be a lifeline to establish or grow your business. A small business line of credit can give you flexibility to access working capital when needed. You can use it to buy inventory, meet payroll, or cover any other business expenses.

What is a business line of credit?

Small business lines of credit are similar to credit cards. They provide a financial cushion that a business can draw upon as needed. Unlike a traditional term loan, where you receive a lump sum of money upfront, a line of credit provides a revolving account. This means you can draw funds up to a certain limit, repay them, and then borrow again. You only pay interest on the amount you've actually borrowed, not the entire credit line available to you.

For example, if you have a $50,000 line of credit and draw $10,000 for inventory purchases, you would only pay interest on that $10,000. Once you repay it, you'll have the full $50,000 available again.

‍

Who needs an SMB line of credit?

Most businesses can benefit from small business lines of credit at some point. Any time you have unexpected expenses or need short-term funding, a line of credit can help. Here are some instances where it can be useful:

• Seasonal businesses: If your business experiences seasonal fluctuations, a line of credit can help you maintain operations during slow periods.
• Cash flow gaps: Companies with inconsistent revenue streams often face gaps in cash flow that a line of credit can fill.
• Unexpected expenses: Whether it's equipment failure, sudden opportunities for growth, or unplanned overhead costs, unexpected expenses can derail a small business. A line of credit can help you cover these expenses.
• Expansion and growth: If you're looking to take on a new project, expand your product line, or enter a new market, a line of credit can offer immediate funds.
• Inventory: Businesses that rely heavily on inventory can use a line of credit to make bulk purchases or capitalize on discounts offered by suppliers.

‍

Who is eligible?

Eligibility for a small business line of credit varies depending on the lender, but there are several common factors that most lenders consider:

• Credit score: A high personal and business credit score can significantly improve your chances of getting approved. Most lenders prefer a score of around 680, although some cater to those with lower scores in exchange for higher interest rates.
• Business revenue: Lenders typically want to see a steady inflow of income to ensure that you can repay the borrowed amount. Some might require a minimum annual revenue — often at least $100,000 — to consider your application.
• Time in business: Many lenders require that a business be operational for a minimum period, often at least one to two years, to gauge its stability and earning potential.
• Financial statements: You'll likely need to provide comprehensive financial statements, including profit-and-loss statements, balance sheets, and cash flow statements.
• Existing debt: If your business already carries a significant amount of debt, lenders may be hesitant to extend additional credit. Most prefer to see a low debt-to-income ratio.
• Collateral: For secured lines of credit, you'll need to offer assets as collateral, such as real estate, equipment, or inventory. The value of these assets can impact both your eligibility and your credit limit.

‍

How does it work?

There are several steps to securing a small business line of credit. You’ll need to get your financial information together and fill out an application to get the process started.

Application and Approval

First, you'll need to apply for the line of credit through a financial institution, such as a bank, credit union, or online lender. The application typically requires financial documentation like business tax returns, financial statements, and bank records.

The lender will assess your creditworthiness by examining factors such as your credit score, business revenue, time in business, and existing debts. If you're applying for a secured line of credit, you must also provide collateral, such as business assets, real estate, or inventory.

If approved, the lender will set the terms of the credit line, including the maximum amount you can borrow, the interest rate, and any fees. They will also specify the repayment terms, including the minimum payments and the frequency of those payments.

Access and Use

Once approved, you can draw funds up to the approved credit limit for a set amount of time. This phase is called the draw period, and it can last several years, depending on your agreement. Unlike a traditional loan, you can make multiple draws at different times as long as the total borrowed amount doesn't exceed the credit limit. The funds are usually accessible through a business checking account, allowing you to use them almost immediately for various business needs.

Interest and Fees

Interest accrues only on the amount you've borrowed, not the total line of credit. Rates can be variable or fixed, depending on your agreement. Some lines of credit come with annual fees, maintenance fees, or withdrawal fees. Always read the fine print to understand the total cost of borrowing.

Repayment

As you repay the borrowed amount, your available credit replenishes, allowing you to borrow again up to the credit limit. You'll need to make regular minimum payments, usually including principal and interest. Some lines have a "draw period" where you can make interest-only payments.

After the draw period ends, you may enter a repayment phase where you can no longer draw funds and must work on paying back the outstanding balance. Many lines of credit allow for early repayment without prepayment penalties, but it's essential to confirm this with your lender.

‍

Alternatives to an SMB line of credit

A small business line of credit isn’t always the best option for financing your business. Depending on your business model and needs, you might prefer another option, such as one of the following.

Merchant cash advances

When you choose this funding option, a lender provides a lump sum, which you repay with a percentage of your daily credit card sales. A merchant cash advance can be a great option if you need funding quickly. Novo Funding provides up to $75,000 in business capital. You can apply in as little as 10 minutes and get a decision in 24 hours.

Angel investors and venture capital

For businesses looking to scale rapidly, selling equity to angel investors or venture capital firms can provide some much-needed cash. While you don't have to repay these funds, you do give up ownership and control over your business.

SBA loans

The U.S. Small Business Administration backs various loan programs for small businesses, offering lower interest rates and longer repayment terms. While attractive, these loans often have stringent eligibility criteria and a lengthy application process.

Takeaways

Securing funding for your business doesn’t have to be a chore. You have many different options, so you should do some research to find one that works best for you. If you’re looking for quicker and easier options than traditional loans or lines of credit, check out Novo Funding. Apply today for fast, flexible funding to meet your short-term financial needs.

‍

Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.

Merchant Cash Advance products and services are offered by Novo Funding LLC (“Novo Funding”), a wholly owned subsidiary of Novo. Merchant Cash Advances require a Novo checking account.

Novo is a fintech, not a bank. Banking services provided by Middlesex Federal Savings, F.A.: Member FDIC.

‍