What is a Line of Credit?

A line of credit (LOC) is a flexible financing arrangement that allows businesses to borrow funds up to a pre-approved limit whenever needed.

Unlike a traditional business loan that disburses a lump sum amount, a line of credit allows borrowers to withdraw smaller amounts over time and pay interest only on the amount used.

It functions similarly to a credit facility where:

  • The lender sets a maximum borrowing limit.
  • The borrower can withdraw funds multiple times.
  • Interest applies only to the withdrawn amount.
  • The credit limit replenishes after repayment.

For example:

In a regular loan of US$10,000, interest is charged on the full amount.

In a line of credit of US$10,000, if only US$200 is withdrawn, interest applies only to that US$200.

This structure helps businesses avoid unnecessary interest payments on unused funds.

Key Features of a Line of Credit

A line of credit typically includes:

  1. Pre-approved borrowing limit
  2. Revolving credit structure
  3. Flexible withdrawals
  4. Interest charged on utilized amount
  5. Defined draw period and repayment terms

Because of this flexibility, businesses commonly use lines of credit for working capital management.

Common Uses of a Line of Credit

Businesses use a line of credit to manage short-term and operational expenses such as:

  • Payroll management
  • Inventory procurement
  • Vendor and supplier payments
  • Marketing expenses
  • Rent and utilities
  • Seasonal demand fluctuations
  • Emergency or unexpected expenses

A working capital line of credit ensures that cash flow disruptions do not interrupt day-to-day operations.

For example, during sudden increases in demand or unexpected events like natural disasters or urgent compliance costs, businesses can access funds quickly without applying for a new loan.

Where Can Businesses Apply for a Line of Credit?

Businesses can obtain a line of credit from:

  1. Commercial banks
  2. Government-supported institutions such as the Small Business Administration (SBA)
  3. Private lenders
  4. Online financial platforms

Approval depends on the lender’s evaluation of creditworthiness, revenue history, and financial performance.

Types of Line of Credit

Lines of credit are broadly categorized based on collateral requirements.

Secured Line of Credit

A secured line of credit requires businesses to pledge assets as collateral.

Common collateral includes:

  • Accounts receivable
  • Machinery and equipment
  • Inventory
  • Commercial property
  • Stocks or insurance policies

Benefits of secured credit lines:

  1. Lower interest rates
  2. Higher borrowing limits
  3. Easier qualification standards

However, in case of default, the lender may liquidate pledged assets.

Unsecured Line of Credit

An unsecured line of credit does not require collateral.

However, approval generally requires:

  • Strong credit score
  • Consistent revenue
  • Positive repayment history

Unsecured lines are harder to obtain but eliminate the risk of asset seizure.

Also Read: The US Ex-Im Bank

How Does a Line of Credit Work?

The process of obtaining and using a line of credit typically involves:

  1. Submission of business documents such as tax returns, incorporation papers, licenses, and financial statements.
  2. Evaluation of creditworthiness by the lender.
  3. Issuance of a credit agreement detailing credit limit, interest rates, and repayment terms.

Most lines of credit come with a draw period, usually lasting one to two years. During this time:

  • Businesses can withdraw funds multiple times.
  • Each withdrawal reduces the available limit.
  • Repayment restores the available credit.

After the draw period ends, the borrower may renew the line or repay the outstanding balance.

This revolving nature makes a line of credit an effective liquidity management tool.

Line of Credit Interest Rates

Interest rates for a line of credit can range from 3.8% to over 40% annually, depending on:

  • Credit profile
  • Business financial strength
  • Secured vs unsecured structure
  • Lender policies

Interest is generally calculated monthly using the formula:

Annual Interest × Outstanding Balance × Number of Days ÷ 365

Since interest applies only to the outstanding balance, businesses avoid paying for unused credit.

Advantages and Disadvantages of a Line of Credit

Advantages

  • Interest charged only on used funds
  • Flexible and revolving structure
  • Quick access to capital
  • Helps maintain steady working capital

Disadvantages

  • Interest rates may be high
  • Variable rates can fluctuate
  • Requires strong financial discipline
  • May have limited consumer-style protections

Line of Credit vs. Letter of credit vs. Overdraft

Letter of credit

  1. The letter of credit (LC) is a document that the importer's bank issues to the exporter's bank whenever the former promises to pay for a purchase of the latter's goods after delivery.
  2. LC involves four main parties: the buyer, the seller, and their respective representative banks
  3. The entire operability of a letter of credit revolves around a fixed amount of money

Line of credit

  1. Line of credit is a financing avenue that helps businesses flexibly borrow money from a lender up to a revolving credit limit
  2. Line of credit involves a lender and a borrower.
  3. Businesses can withdraw any amount of money within the total credit limit from the credit line.

Overdraft

  1. An overdraft lets users withdraw more money than the balance present in their current account
  2. Overdrafts involve two parties: a financial body and an account holder
  3. Unlike a line of credit or letter of credit, overdrafts also involve negative balance amounts

Frequently Asked Questions About Line of Credit

1. Is a line of credit beneficial for businesses? Yes, a line of credit can be highly beneficial for businesses that need ongoing access to working capital. Unlike a traditional term loan, it provides flexibility to borrow only when required and pay interest only on the amount used.

It is especially useful for managing short-term expenses, handling seasonal fluctuations, covering payroll, or purchasing inventory without disrupting day-to-day cash flow.

However, businesses must manage repayments responsibly, as high utilization or missed payments can increase costs and impact creditworthiness.

2. When should a business consider a line of credit? A business should consider a line of credit when:

  • Revenue is seasonal or inconsistent
  • There are frequent working capital gaps
  • Supplier payments need to be made before receivables are collected
  • Unexpected expenses arise
  • Growth opportunities require quick funding

It is ideal for short-term operational needs rather than long-term capital investments.

3. Is interest on a line of credit tax deductible? In many cases, interest paid on a business line of credit may qualify as a deductible business expense, provided the funds are used strictly for business purposes.

However, tax treatment varies by jurisdiction and business structure. Companies should consult a certified tax professional to confirm eligibility and compliance requirements.

4. What credit score is typically required for a line of credit? Most lenders prefer a credit score of 600 or above for approving a business line of credit.

Higher credit scores generally result in:

  • Lower interest rates
  • Higher credit limits
  • More favourable repayment terms

Lenders also consider revenue stability, profitability, debt levels, and overall financial health alongside credit score.

5. Does using a line of credit affect credit score? Yes, a line of credit can impact a business’s credit score in multiple ways.

Positive impact:

  • Timely repayments improve credit history
  • Responsible utilization demonstrates financial discipline

Negative impact:

  • High credit utilization ratios
  • Late or missed payments
  • Default or restructuring

Maintaining low utilization and consistent repayments helps strengthen credit profile.

6. What credit score is needed for a Line of Credit? Businesses generally need to maintain FICO scores of more than 600 to get credit lines.

7. Does a Line of Credit affect the credit score? The credit score of a business depends on how well or poorly it manages to repay its line of credit dues. If businesses leave it late to repay the dues, their credit score will be negatively affected.

8. What is the easiest Line of Credit to get? Secured lines of credit are relatively easier to get compared to unsecured ones.