More than half of new businesses fail in the first five years. The main reason for this is the lack of cash to keep the business operating. Finding new sources of capital to keep the business running should be a top priority when starting a new venture.
Getting a line of credit is one way to tackle the cash flow obstacle. Though it may sound similar, a line of credit is not a credit card.
Check out this guide to getting a line of credit to learn how your business can use it to your advantage.
What Is a Line of Credit?
A line of credit is a type of loan from the bank that allows you to borrow for a specific purpose. An example is the home equity line of credit (HELOC) homeowners use for remodeling. A line of credit extends to both business and personal use.
Unlike a traditional business loan, however, a line of credit isn’t issued all at once. You also don’t receive the money in lump sums. Instead, you have access to a lump sum of money that you can take as needed.
If you don’t borrow the full amount available to you, you are not responsible for paying it back. There is no money due to the bank until money is drawn. This fact does make the line of credit like a credit card, but the rules are different.
When you use the money available to you in the line of credit, it’s called a draw. The main difference between a line of credit and a credit card is the way interest is calculated. Banks consider credit cards a higher risk than a line of credit making interest rates higher for them.
A line of credit usually comes with a much higher spending limit than a credit card. Homeowners can have hundreds of thousands of cash available to them with a home equity line of credit. It just depends on how much equity their home has accumulated over time.
Each month the bank sends a statement showing the balance on your account. The statement includes the minimum payment you need to make and an overview of interest and fees.
While you draw down funds, these statements will continue to reflect payment amounts. The payment amounts will vary based on how much you actually spend.
Getting a Line of Credit
The idea of access to a large lump sum of money can make some people nervous. If you’re an entrepreneur with no other access to capital and want to start a business, a line of credit may be your best option.
Cash flow problems can snowball leaving you in higher cost debt than a loan from your bank. A line of credit gives you leverage to do things like buying new inventory for a product you want to sell, pay rent on office space, or hire new employees. These expenses are repaid as your company begins to bring in revenue.
When to Use a Line of Credit?
The best time to use a line of credit for your business is to cover the cost of large overhead expenses you could not otherwise afford. You get to repay the debt in installments rather than being responsible for the entire balance at once.
Use a line of credit to also help your business get more customers. When you put your line of credit into the right areas of your business, you can increase sales. You can invest in getting the best quality inventory to help your product stand out, for example.
Salaries are a high overhead that can yield high returns. Hiring the best people to represent your business is one way to help your company get a competitive advantage long term. It’s important to arm yourself with ways to keep earning money to repay your line of credit.
Qualified staff, a great office location, and a good product are three simple ways a small business owner can compete for customer attention. Lines of credit, however, are finite. You can’t spend an infinite amount of money so it is important to be conservative when choosing how much to spend on salaries, rent or equipment.
A line of credit can also serve as an emergency fund for your business giving you access to much-needed access in the event of a tragedy. It can also help support a financial gap where another loan falls short.
Secured vs. Unsecured
There are two main LOC types available for borrowers. The first is secured and the second type is unsecured.
A secured line of credit requires collateral like your home, car, or another asset. A LOC that requires personal collateral to secure the debt is usually a lower risk or the bank which means a lower interest rate for you.
The bank considers a secured line of credit a low risk because if you default on the loan, they can take your collateral instead. The bank might auction off the collateral to repay the debt in cash or keep it while you try to bring your account back into good standing.
An unsecured line of credit requires no collateral. This type of loan is considered a much higher risk than a secured line of credit. Interest rates are higher on an unsecured line of credit to account for the higher risk loan.
Without established business credit or revenue, an unsecured line of credit is difficult to get. Many new businesses use their personal line of credit to support the initial cost to start a business.
Personal Lines of Credit
Using personal property, like a home, is one common way to get a secured line of credit. The equity in your home is used as collateral for the debt in this case. This home equity line of credit can offer your business a short term loan while in its startup phases.
Apply for a personal line of credit where ever you maintain a checking account. Most banks require that you first have an account before applying for this type of loan. If you are approved for a line of credit, you simply transfer money from the loan account into your personal checking account.
A line of credit account sometimes has checks attached to it that allow you to pay directly from the account. The way you use the funds is up to you as long as the loan is repaid according to the terms you agree to with your bank.
Business Line of Credit
Established businesses have a much better chance of getting access to a line of credit than new companies. Use a business line of credit as a way to grow your business. Think of hiring more employees or upgrading equipment to help you get access to more sales.
This idea makes sense when there are opportunities waiting that you can’t take advantage of until you do the necessary business upgrades. Businesses often use lines of credit finance short term needs like new inventory, covering operating costs during slow seasons, and new equipment.
A business line of credit can be secured by assets your business owns. If you are a startup, but own commercial land or other assets, you can use them to secure your loan. The major challenge to a business line of credit is with entrepreneurs who have no experience and no assets to back the loan.
Before You Apply
Review your credit report before applying for a line of credit. Find out what your credit score is and whether there are any errors on your credit report that may affect your score. It’s best to make sure your credit score is at its highest before applying for a LOC.
Your credit score at the time of your loan application determines your interest rate. Depending on how much you plan to borrow, the difference between a high and low-interest rate can be thousands of dollars.
Request your credit report from the three major credit bureaus to make sure all information is accurate. A free copy of your credit report is available each year from each credit bureau if you are a U.S. citizen.
Next, gather your financial records including pay stubs, tax returns, bank statements and any other information that shows your assets. With a personal line of credit, the kind of job you have and where you live can impact your ability to get a loan.
Pay outstanding tax debts and be sure current loan payments are all current. When applying for a business line of credit, your entity must be established before you apply for the LOC. Licenses and sales permits must also be in place.
Getting a line of credit is a major financial step for any business. Money solves many operating problems, but not all. If you gather your financial documents and learn that your debts cannot be repaid before applying for a loan, you may have a bigger financial management problem than a line of credit can fix.
A line of credit helps boost your business, not save it from ruin. Talk to a small business counselor in your area for tips on changing course if your business finances look bleak.
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