A Guide To Understanding Lines of Credit

Here's an ultimate guide to understand what a line of credit is ("LOC"), when to use it, and where to get one!

What is a Line of Credit?

 
A line of credit is debt that you can access at any point in time without an explicit deadline for when you need to pay back the principal (more on that later). It gives you access to a set amount of money (your credit limit) that you can tap into as needed. You only pay interest on the amount you borrow, and unlike a traditional loan, you can repay and reuse the funds repeatedly. It's like having a financial safety net for emergencies or short-term needs.

LOCs are approved and will be authorized for your business to use for 1-3 years, after which bankers will need to re-approve the LOC for your busienss. If things are going well and you consistenly pay down the principal balance, they may increase your credit limit, and vice versa. 

While a LOC doesn't have an amortization schedule like a normal loan (amortization schedule = the monthly payments that you are required to make to pay back the loan balance over time), carrying a balance for a long-time is disadvantageous, as your lender will have concerns about your ability to repay the principal balance. If they don't renew the line of credit at the expiration date, that could put you in a bind, as the entire balance will need to be repaid.

When To Use a LOC

Actually, let's start with when not to use a LOC:

• To pay for someone's salary
• To buy land, a car, or other long-term / non-cash flowing assets
• To pay yourself more
• To fund a big marketing and advertising campaign

All of these things have a couple things in common: 1) They are long-term assets and / or 2) there is no guarantee that they will generate any cash flow for your business.

On the flip side, here are some ways that a LOC can be used well:

• Purchasing inventory for an e-commerce business
• Buying supplies and materials to renovate someone's house
• Buying food and equipment for catering an event

All these things are related by a simple fact: the proceeds from the LOC are all being allocated towards assets that will convert to cash within a year (hopefully less). In finance-speak, we would say that you are funding your working capital deficit with a LOC. In human-speak, it means that you have spend money to then make money; instead of you floating the cash to make that happen, the bank will. 

Some grey areas for using a line of credit:

• Funding payroll: Ideally, you should have enough cash to cover ~3+ months of operating expenses, including payroll. If you can't cover payroll and it's because customers are late to pay you, that's understandable and a LOC would be appropriate. If you can't cover payroll because you're business is unprofitable, that's another story...
• Buying shelf-stock: It makes sense to have extra inventory on-hand just in case something happens. What makes shelf-stock unique is that there is no specific timeline in which those items will turn into cash. Evaluate how quickly your shelf-stock items are sold / used and that will give you a good baseline for whether a LOC is appropriate. 

Where to Get A Line of Credit

Traditional banks are typically the go-to LOC providers, while there are some alternative lenders that provide faster (albeit more expensive) LOC options.

I'd start with talking to your existing banking partner(s). Given they handle your checking and savings accounts, I'd bet that they'd be the most interested in extending a LOC to you. 

From there, talk to other businesses in the area to get a list of places to apply to. From there, it's just a competition to see who can give you the best offer. Here's what I'd look for when evaluating a LOC:

• Interest Rates: Shop around! Rates can vary significantly. Aim for the lowest rate possible.
• Fees: Beware of annual fees, origination fees, and inactivity fees.
• Secured vs. Unsecured: Secured LOCs require collateral (like your house) and often offer lower rates. Unsecured LOCs are based on your creditworthiness.

Also note, a lender will want to know that you've been in business for a year or more, are profitable, and have (at least some) money; they are going to want business financials, personal tax returns, bank statements, and some other pieces of information. 

The Final Takeaway:

Used responsibly, a LOC can be a valuable financial tool. Remember, it's not free money! Only borrow what you have a plan to repay, and have a plan in place to pay it down quickly. With careful management, a LOC can be your financial partner in weathering life's stormy financial seas.

Bonus Tip: Before applying for a LOC, check your credit score. A good score will qualify you for better rates and terms.

This blog is for informational purposes only and should not be considered financial advice. Always consult with a qualified financial professional before making any financial decisions.