Summary of a business line of credit
A business line of credit gives you access to a predetermined amount of money from your bank. Unlike a bank term loan, you only pay interest on the amount you have drawn from your line of credit. For example, if you have a business line of credit of $50,000, you can borrow up to that credit limit. If you are only using $20,000 of the $50,000, you will only pay interest on the $20,000.
There is usually no set term on this type of business finance, so there’s no expectation that you will pay the loan within a certain timeframe. Based on your cash flow, you can choose when you want to reduce the principal. However, you won’t be required to pay the entire amount as long as the line of credit is open, which is indefinite but subject to review, usually every five years.
In addition to the interest on the amount you are borrowing from the funds available, there are fees as well. This includes an establishment fee which is a percentage of the total amount. For example, one bank charges an establishment fee of 0.75% of the total credit limit. So if the credit limit is $100,000, the establishment fee will be $750. There is usually a monthly service fee, also called a line fee, which typically ranges between $20 and $30 per month.
Reasons for getting a business line of credit
This form of business finance can be used for a range of purposes, from short-term to long-term. In the short term, you could use the funds to improve your cash flow. For example, if you have had a busy period in your business and are waiting for invoices to be paid. In this case, you need to pay for expenses related to making the sales but you won’t be paid immediately. Alternatively, you could be heading into a busy season and need cash to increase your inventory to be ready for increased sales.
In the long term, you could use the business line of credit to open up new opportunities in your business. If you see demand for a new product but aren’t offered trade credit from the vendor, getting the needed funds can help you expand your product range. Another common use of this type of finance is for marketing campaigns. In this case, you can use the funds for marketing which can take some time to generate sales and income.
What are the requirements for getting a business line of credit?
A bank will want to analyse your business financials to determine whether you qualify for the business line of credit and what the approved limit will be. This will include looking at financial reports and tax returns from the past two years, your income and your credit report. The lender will also want to know what you plan to use the funds for, to ensure that you will be able to generate income to make the interest payments on the amount you are borrowing.
It’s usually secured by the equity in your home but can also be secured by commercial real estate. Since residential property is seen as less risky and easier to sell than commercial property, you can borrow more of the property value when using residential property as security for a business line of credit. With falling prices, however, more and more banks are reducing or eliminating finance which uses residential property as collateral.
Pros of a business line of credit
- Although the interest is higher than a business term loan, it’s less than the interest rate for business credit cards or a business overdraft.
- You get the flexibility to access funds as you need them and draw down the line of credit at your discretion.
- You only pay interest on the money you are using.
- There is no term for a business line of credit.
- It’s easy to access funds through online banking, EFTPOS or cheque.
- You only need to make interest payments, which is helpful when you are short of working capital.
Cons of a business line of credit
- It can be tempting to overuse the business line of credit and end up continuously paying a large amount of interest. Discipline is required. Business owners need to ensure the funds are used wisely and only when needed.
- There are fees and charges, including an establishment fee and ongoing monthly line fees.
- More paperwork required for approval than for other loans, such as personal loans, business overdrafts and unsecured business loans.
If choosing between a business overdraft and a business line of credit, consider your funding requirements. Although the interest rate for a business line of credit will be lower, an overdraft can be more suitable for short-term funding needs.
Alternatives to a business line of credit
If borrowing money for short-term business needs, consider the alternatives. Online unsecured business loans require minimal paperwork and are approved quickly. With Moula, for example, the application takes around 10 minutes to complete. In addition, your data is safely and securely analysed online to determine your eligibility and the amount of the loan. Once approved, the funds are transferred immediately to your bank account. Learn more about unsecured business loans from Moula.
Another alternative is Moula Flex, a fast and flexible line of credit available to businesses using Xero accounting.
For an overview of business loan options available, read The Complete Guide to Business Loans in Australia.