If you are considering launching a startup, you probably have a passing familiarity with all sorts of options for business funding. You know about bootstrapping, and hopefully, you dismissed that option right away. You know about venture capitalists and angel investors, but you might not be keen on selling a portion of your business to rich strangers. Your best option, then, is business debt — but small business loans aren’t your one and only choice.
Business lines of credit are another form of business debt that gives you access to money to pay employees, buy equipment and otherwise build your business. However, business lines of credit don’t function the same way as more familiar forms of debt, like loans or credit cards. If you are interested in learning about a new funding source for your startup, look no further than a line of credit.
How Does a Line of Credit Work?
A business line of credit is like a midway point between a business loan and a business credit card. On one hand, like loans, lines of credit have a lengthy application process and are typically limited to certain types of purchases. On the other hand, like credit cards, lines of credit have a balance that you draw down from, and you only pay interest on the money you spend. It’s the perfect marriage of business debt, and it is an exceedingly useful financial tool for nearly all businesses.
Lines of credit typically have large borrowing limits, ranging from $5,000 to hundreds of thousands of dollars, but they typically offer less money than a term loan your business can acquire. There are two main types of lines of credit: secured and unsecured. As you might expect, a secured line of credit relies on collateral, perhaps some valuable asset, inventory or cash; in return, you can enjoy lower interest rates, more flexible payment terms and other positives. Conversely, unsecured lines aren’t backed by collateral, which on one hand keeps your assets off the hook but on the other hand leads to higher fees. You should pursue the former if your business is young, and SBA advocates for the latter if your business has a solid credit history.
Most often, credit providers want to know how you will use a line of credit. The most common reasons for drawing down on a line of credit include:
- Working capital. If your cash flow is poor — perhaps your business is brand-new or you operate in seasonal waves — you can use a working capital line of credit for access to money to cover payroll and other ongoing expenses. These often come in one-year terms and will revolve, meaning you will have access to the full amount of your balance until the contract ends.
- Asset purchase. If your business needs to acquire expensive equipment and doesn’t have the capital available, you should apply for an asset purchase line of credit. This form is typically non-revolving, meaning the balance doesn’t fill back up once you draw down.
- Real estate. Real estate companies often use massive lines of credit to be certain they have the capital to purchase property at a moment’s notice. These are also commonly called guidance lines because payments don’t require individual approval, so the process of using the line of credit is fast.
What Businesses Can Get Lines of Credit?
In theory, any business can obtain a line of credit. In practice, businesses with a few years under their belt are more likely to gain access to lines that have favorable terms and practical use. Still, business lines of credit for startup companies do exist; they just might be secured, have floating rates, lower balances and other limitations.
Regardless, most businesses should pursue at least one line of credit. Experts agree that the best time to apply for a line of credit is when you don’t need one. This is because providers scrutinize business health and creditworthiness prior to offering lines, and the application process can be lengthy. You don’t want to begin applying for a line of credit in the midst of a crisis; by the time you get one, it won’t be much help. Since lines of credit cost little to uphold — you only pay interest on the balance you use — you might as well keep a line of credit available, just in case.