What is a line of credit?
A line of credit is a loan account that allows businesses or other entities to draw funds as and when they need them on an ongoing basis. It acts as an open-ended loan in which the lender decides the maximum credit amount that a business can access, giving the borrower the flexibility to draw funds whenever they need them. It is different from a typical business loan and functions more like a credit card, where the borrower can draw money any number of times, as long as it is within the credit limit. The borrower only repays the amount used by them and not the entire sum like a regular business loan.
For instance, when a business takes a loan for US$10,000, it gets access to the amount in one go and is expected to pay interest on the entire amount until it is fully repaid. On the other hand, if a business gets a line of credit worth US$10000, it can draw smaller amounts like, say, US$200 when needed and will only need to repay this amount with interest, and not the entire sum. In the longer term, this gives the business the option of borrowing up to US$10,000 but enables them to avoid high-interest payments for unutilized cash unnecessarily.
Uses of a Line of Credit
Businesses generally use lines of credit to meet their short-term capital needs. This could be to maintain healthy cash flows, procure supplies, or manage payrolls on a monthly basis. Businesses can also access lines of credit as a means to deal with unexpected liabilities or capitalize on emerging opportunities.
For example, if a business needs extra money due to an unexpected event, such as unexpectedly high demand volumes, a natural calamity, or legal penalties and compensation, it has easy access to cash without having to apply for more loans and straining its finances.
Where to get/apply for a Line of Credit?
Businesses can apply for a line of credit from banks, government-run financial institutions like the Small Business Administration (SBA) in the US, or private lenders. Before approving the line of credit, such institutions will verify the creditworthiness of the business.
Types of Line of Credit
Business lines of credit can be classified into two types based on whether the line of credit involves the securing of collateral against the amount borrowed or not.
Secured lines of credit
Businesses need to nominate certain assets as collateral before a lender approves this type of credit line. The enlisted assets should be of equal or greater value collectively than the total credit amount available for withdrawal. A secured line of credit has lower repayment interest rates and provides a higher credit limit for businesses to tap into. Additionally, the creditworthiness parameters are relatively less stringent in this option, as lenders consider it a safer money lending avenue. In case of a payment default, the lender can seize or liquidate the assets listed as collateral in the credit line documents. Collateral normally includes accounts receivable, machinery and other inventory, company property, stocks, shares, insurance policies, or business guarantees.
Unsecured lines of credit
On the other hand, unsecured lines of credit do not include collateral. However, a business will need to have a perfect repayment record and credit rating before the lender can approve an unsecured line of credit for their business operations. Unsecured lines of credit are much harder to get for a large majority of businesses as not many may have a perfect credit history.
Also Read: The US Ex-Im Bank
How does a Line of Credit work?
The business looking for a line of credit provides documents to verify its name, location, loan purpose, proof of collateral, legal documents, and business tax ID. The lender evaluates the overall creditworthiness of the entity based on records such as tax returns, business licenses, articles of incorporation, annual financial statements, loan repayment records, business plans, and bank statements of the business and owners.
Once the lender verifies the eligibility of the business on the basis of all the presented documents, they issue a loan agreement in the organization’s name that includes details such as total credit limit, draw period, repayment period, and interest rates.
The business uses the credit line to maintain its working capital and cash flows at a steady level consistently. So, even on occasions when revenue is lower than expected, businesses can pay for salaries, operational expenses, inventory purchases, supplies, rent, marketing, and other expenses using the credit line.
The terms governing a line of credit change from lender to lender, and are clearly defined in the loan agreement. The agreement defines things like the maximum amount that the borrower can access, the interest rates, and also the duration of the credit line that remains valid. Business lines of credit generally come with a specific draw period, which is the period during which a business can withdraw money from the account. The draw period usually lasts for one to two years. After this, the business can either renew the credit line or repay the total amount drawn with interest. Within this period, the borrower can draw funds as many times as they need to.
Every time they withdraw an amount, it is deducted from the maximum limit. They can repay the amount within the defined billing period, along with the interest. Once they repay the amount, the total limit gets replenished again.
Line of Credit Interest Rates
Credit lines for businesses can have repayment interest rates as low as 3.8% to as much as 40% and above. Lenders calculate the repayment interest rates on a monthly basis. In the computation of this interest rate, the variables involved are the outstanding re-payable amount of money from the previous billing cycle (generally taken to be 30 days), the number of days in a month, and the annual interest rate.
The formula for calculating the interest rate for business lines of credit is given by
Annual interest × outstanding balance of previous billing cycle × No. of days in the given month ÷ 365
Pros and Cons of a Line of Credit
Just like any other trade finance option, a line of credit represents a decent avenue for financing the daily operations of a business. However, it has several issues too.
- Unlike standard loans, businesses do not have to go through a drawn-out application process
- Businesses need to only repay the money they withdraw from the account
- Credit lines enable businesses to maintain healthy working capital regardless of their overall economic situation
- Lines of credit do not have the regulatory protections that credit cards do
- The interest amount of a credit line is not tax-deductible
- Credit lines normally tend to have large interest rates
Line of Credit vs. Letter of credit vs. Overdraft
Letter of credit
- 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.
- LC involves four main parties: the buyer, the seller, and their respective representative banks
- The entire operability of a letter of credit revolves around a fixed amount of money
Line of credit
- Line of credit is a financing avenue that helps businesses flexibly borrow money from a lender up to a revolving credit limit
- Line of credit involves a lender and a borrower.
- Businesses can withdraw any amount of money within the total credit limit from the credit line.
- An overdraft lets users withdraw more money than the balance present in their current account
- Overdrafts involve two parties: a financial body and an account holder
- Unlike a line of credit or letter of credit, overdrafts also involve negative balance amounts
FAQs on Lines of Credit
1. Is a Line of Credit good or bad? Lines of credit have their own positives and negatives. So, while they are useful instruments to raise money for business operations, businesses need to maintain high creditworthiness to avail them.
2. When is a Line of Credit useful? Lines of credit are useful to sustain daily business operations consistently for businesses, despite day-to-day unpredictabilities.
3. Is the Line of Credit interest tax deductible? The interest on a line of credit is not tax-deductible.
4. Which Line of Credit is the best? For businesses, the unsecured type represents the most risk-free line of credit option of all.
5. Is the Line of Credit interest rates annual? The line of credit interest rate is generally calculated on a monthly basis.
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.