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Business Line of Credit

Shaun McGowan By Shaun McGowan
A business line of credit or ‘LOC’ is a flexible short-term business finance facility, which operates in a similar way to an overdraft.

What is a business line of credit?

A business line of credit (or ‘LOC’) is a flexible short-term business finance facility, which operates in a similar way to an overdraft.

With a line of credit, you’ll be given an approved amount you can borrow, which will then be available for you to draw on (use) whenever you need it.

Business Line of Credit

Unlike a traditional loan, you won’t start paying interest until you actually need to use the funds – and that interest will only be calculated on the amount you draw down, rather than on the full amount of the facility.

A business line of credit can be offered to you as a single-use facility, where you can access funds as you need them until you have borrowed the full amount available to you, or as a revolving facility.

With a revolving facility you will be able to draw, repay and redraw the funds just as you would with an overdraft, giving you ultimate flexibility.

Business Line of Credit Revolving Facility

A LOC can be secured or unsecured – if you have assets to offer as collateral this will lower the risk (and therefore the cost) of your facility, but it will mean that you won’t be free to dispose of those assets until the facility has been repaid.

Who uses business lines of credit?

Business line of credit facilities are popular with business owners who want fast, flexible access to cash without the risk of being locked into long-term debt they may not need – and who don’t want to pay interest on funds that they aren’t using.

A LOC can be a good option if you are willing to pay extra for that flexibility and for the peace of mind of knowing you have the funds at your fingertips should you need to cover an unexpected expense, or to act fast to secure a business opportunity.

Business Line of Credit Unexpected Expense

An additional benefit of having a revolving LOC is that you don’t have to get approval if you need funds again, although the facility will be reviewed once in a while.

What is the purpose of a business line of credit?

You can use your LOC for any purpose, as you won’t have to get approval from your lender each time you draw down funds. It is ideal as a back-up for working capital, and for taking advantage of business opportunities like bulk stock sales.

Business Line of Credit Purposes

However, a business line of credit is a short-term finance facility which means it is not suitable for funding major capital investments or long-term business needs.

Generally, a LOC will have a fixed term (generally between 3 and 30 months. It is common for revolving LOCs to be ongoing, with a review at fixed intervals such as every one or two years. There is no guarantee that you will be able to renew your facility at the review point, and the lender will typically have the right to withdraw the facility at any time.

Like most forms of short-term business finance, interest rates tend to be higher than for long-term funding options like a mortgage, so using a LOC for major purchases is likely to be costly as well as risky.

How much does a business line of credit cost?

As with other types of business finance, the cost of a line of credit will depend on many factors. These will include:

  • How much you want to borrow
  • Whether your facility is secured or unsecured
  • Whether your facility is fixed or revolving
  • The agreed repayment terms
  • Your credit rating
  • Your average turnover
  • Your income and expenditure patterns

When it comes to setting your credit limit, your lender may look at your cash flow forecasts to determine your repayment capacity, or they may use pre-determined percentage of your gross revenue. Each lender will have their own criteria for assessing how much you can afford to borrow, and their own risk appetite.

The way you’ll pay for your line of credit will be different from a business loan. You’ll still pay interest at a rate determined by the lender (based on the factors outlined above), but you’ll only start paying interest when you begin to draw down funds, not when you set up the facility.

As with an overdraft or business credit card, interest will only be calculated on the daily balance you owe, not on the full credit limit available to you. Usually you’ll need to make monthly repayments, but some lenders may allow you to negotiate a payment schedule that matches your income patterns.

As with credit cards or overdrafts, the amount of interest you owe will be added to your loan balance. So if you’re only making the minimum monthly payments, you won’t be paying back the principle fast enough, and interest can compound quickly.

Business Line of Credit Compound Interest Formula

Since your lender won’t be able to earn interest on those funds from another source while they are committed to you, they will need to be compensated for making the funds available to you. You can therefore expect to be charged an initial set-up fee, and possibly an ongoing monthly service fee, for your facility.

Application or set-up fees for a LOC facility are typically calculated as a percentage of your approved credit limit – anywhere from 0.50% and 3% is common, and there may be a minimum fee.

When it comes to comparing the price of LOC facilities, make sure you get details of all those fees and charges so you can establish the true comparable cost.

Where to get a business line of credit

While you could approach a high street bank for a line of credit facility, most SMEs will find they don’t meet traditional lenders’ qualification criteria.

If your business hasn’t been trading profitably for two to three years, or if you don’t have assets you can (or want to) offer as security, you’ll find a wide range of lenders in the alternative finance market offering business lines of credit.

Applying for a LOC from an alternative lender is usually a very streamlined process – you’ll need to complete a simple online application form providing information about your business and outlining how you plan to use the funds.

Business Line of Credit Application

The lender will also want to check your credit rating and examine your cash flow to see that you have the capacity to service your debt. You can expect to be asked for copies of your bank statements as well as identity documents for yourself and your business.

Fintech lenders tend to be swift and responsive, so you can expect to get a quick assessment of your application. You could have funds in your account within 24 hours if your application is approved.

How to choose a business line of credit lender

If you’re looking within the fintech market for a line of credit provider, you’ll have plenty of choice. Some lenders may be willing to offer you a facility even if you have a poor credit rating, provided that you have repayment capacity (and are willing to pay a higher rate of interest to compensate them for the increased risk).

Since fintech lenders aren’t regulated in the same way as Australia’s high street banks, it’s important that you research your options carefully. You’ll need to look beyond the advertised interest rates, comparing all the fees and charges – as well as terms and conditions.

Business Line of Credit Terms

Be aware that some lenders may seek to reduce the risk of transacting with you by imposing restrictions on your business. Even the high street banks may restrict you from taking on additional debt while your facility is active, but some alternative lenders may also impose other conditions, such as preventing you from offering credit terms to your customers.

Make sure you understand all the terms and conditions of your LOC product before committing, including whether you have the right to terminate the facility without penalty if you no longer need it.

Not all lenders offer revolving credit lines, so if you need that flexibility you may need to shop around.

Seek recommendations online or among your networks to make sure you are dealing with a reputable lender. A business loan broker can help you compare your options and find lenders that are a good match for your business needs and goals.

Before applying for a business line of credit

As with any business borrowing, it’s vital that you prepare a business case before applying for a line of credit.

Business Line of Credit - Before Applying

As an emergency resource or a back-up for your working capital a LOC can be an excellent option, and one that won’t leave you locked into paying for long- term borrowings you may not need. However, all business finance comes at a cost, and you need to be sure that your facility will help you generate enough extra funds to cover those costs.

A business case, incorporating realistic financial projections, will help you evaluate whether a LOC really will help you grow and strengthen your business.

Another important consideration is that a revolving line of credit requires strict financial discipline. Interest can compound very quickly if you allow your balance to accumulate, and you’ll be paying fees on top of that.

Having ready access to funds can make it easy to act without caution and take your business into debt you can’t afford to repay, instead of rigorously evaluating each opportunity.

It’s worth speaking to your independent financial advisor before making an application, to help you decide if a LOC is the right funding option for your business, and to help you choose the right lender and loan product.

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