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Business Line Of Credit: The Ultimate Guide

Business Line Of Credit: The Ultimate Guide

Business Line Of Credit: The Ultimate Guide to understanding Its Ins & outs

A business line of credit is an arrangement between a financial institution, usually a bank, and a customer, that established the maximum amount of a loan that the customer can borrow when needed.  A line of credit is a credit source extended to a business owner and/or individual by a bank or other financial institution.

What is the business line of credit used for?

Every small business needs to be able to adapt to change, especially in times of growth or uneven cash flow. When you need ready access to cash and flexible terms for repaying borrowed funds, an unsecured line of credit can often be an ideal solution. The number-one reason to open a business line of credit is to gain a backup access to short-term funding. Cyclical businesses often rely on this unsecured line of credit as a source of seasonal working capital.

A business line of credit is a financial instrument typically used for an organization’s short-term working capital needs, such as inventory purchases, future project costs or company payroll. The lines of credit are mainly to help even out your cash flow.

Using a business line of credit, the borrower can access funds at any time, the business owner has a payment facility granted by a bank to be used once necessary as long as he does not exceed the maximum amount set in the agreement and meets any other requirements, such as making timely its repayments.

Different from many small business loans, a business line of credit is not designated for a specific purpose or purchase — it’s a good choice for small businesses looking for ways to better manage cash flow. Funds are typically drawn from the line of credit to a business checking account as long as needed, and then the amount borrowed can be used business as per the business owner preference.

An important caveat: the maximum credit limit cannot exceed 20% of the annual business revenue. For example, a business with $100,000 in annual revenue could be approved for up to $20,000.

Some benefits of using a business line of credit.

  • Competitive interest rates _ Interest rates are generally lower than other types of credit even when compared to business credit card.
  • Access to funds _ access available funds during the draw period by simply writing a check when you need it.
  • Flexible payments _ make payments only on the portion you use.
  • Revolving credit line _ as you pay down the balance, the available credit line amount becomes available for use during the Draw Period.
  • Credit report building _ maintaining a line of credit in good standing may help build your business credit rating and position you for better loan terms if you seek future financing. Many small business experts suggest that first-time applicants should start a modest line of credit and pay off the debt quickly as a way of building a credit profile.

Keeping your small business finances running smoothly can often be a challenge in today’s fast-paced world. Depending on your specific business needs, a small business line of credit could be the simple solution you need to meet your goals for growth.

How do its interest and fees work?

Interest is paid only on money actually withdrawn. (However, the borrower may be required to pay an unused line fee, often an annualized percentage fee on the money not withdrawn).

Such as most of the credit cards, the Line of Credit features variable rates are also based on the Prime Rate published each day in The Wall Street Journal Money Rates Table (the “Index”), plus a margin. The APR can change monthly, but may not exceed 18% APR, or go below 2.99% APR.

The prime rate is the underlying index for most credit cards, home equity loans and lines of credit, auto loans, and personal loans. Many small business loans are also indexed to the Prime rate. The 11th District Cost of Funds is often used as an index for adjustable-rate mortgages.

The federal funds rate is the primary tool that the Federal Open Market Committee uses to influence interest rates and the economy. Changes in the federal funds rate have far-reaching effects by influencing the borrowing cost of banks in the overnight lending market, and subsequently, the returns offered on bank deposit products such as certificates of deposit, savings accounts, and money market accounts. Changes in the federal funds rate and the discount rate also dictate changes in The Wall Street Journal prime rate, which is of interest to borrowers.

Business lines of credit with lower credit limits are typically unsecured, which means collateral such as real estate or inventory is not required.

Most traditional lenders, such as banks, require businesses to have strong revenue and at least a few years of history to qualify for a line of credit. Larger lines of credit may require collateral, which can be seized by the lender if you fail to make payments.

The main payment plan advantage of the business line of credit is its flexibility. You can access a small or large sum as you need it. You don’t have to repay every month (or pay interest) if you don’t need the money. If you want to receive money every month, you can withdraw as much or as little as you need for this month. If you have a big expense, you can take a large withdrawal based on your credit limit allowed. If you receive unexpected funds from another source, you can leave your line of credit intact as a back-up by repaying off the full amount. A line of credit can work as a lump sum payment plan, land or term, which are other options for receiving the proceeds of the reverse mortgage, but this gives the business owner more control over how and when to borrow from its established business line of credit.

Managing your business line of credit

Business owners have control over some of the factors that determine your business line of credit interest rate. An excellent credit score and/or collateral asset can qualify your business to better options of business line of credit; and if your score has improved significantly, you can try asking the issuer for a lower rate. But regardless of the stated APR, you can reduce the effective rate in several ways:

  • Pay your bill in full every month, if possible, to avoid interest
  • Make more than the minimum payment if you can’t pay your bill in full
  • Make payments early and more than once a month to shrink your average daily balance

Paying twice a month or more frequently rather than once can reduce your average daily balance and, therefore, your interest. For example:

You have a balance of $1,000 on the first day of your billing cycle, and you’ll only be able to pay off $600. Assuming a 30-day cycle, if you waited until the due date to pay, your average daily balance would be $980.

($1,000 x 29 days) + ($400 x 1 day) = $29,400.
$29,400 / 30 days = $980.

Now say you paid that $600 on the 21st day of the cycle. Your average balance becomes $800.

($1,000 x 20 days) + ($400 x 10 days) = $24,000.
$24,000 / 30 days = $800.

You can save even more when you “pay as you go” — making multiple payments as the month goes on. Say you paid $200 on the seventh day of the cycle, then $200 on the 14th and $200 on the 21st. Your average daily balance drops to $660.

($1,000 x 6 days) + ($800 x 7 days) + ($600 x 7 days) + ($400 x 10 days) = $19,800.
$19,800 / 30 days = $660.

Paying the same amount on your line of credit but paying it early and in installments reduced the interest in this case by nearly a third.

Banks charge interest on purchases only if you carry a balance from one month to the next. If you pay your balance in full every month, your interest rate is irrelevant, because you don’t get charged interest at all. Obviously, paying in full is the most cost-effective way to go, but if you usually carry a balance, a low-interest can save you money on interest.

Pros and Cons of a Business Line of Credit

When it comes to running a small business, having ample cash flow is imperative. Due to this, many business owners consider pursuing a business line of credit, but might not know about the following pros and cons:

Pros                                                                              Cons

 Improve business adaptability.                   |      Higher interest rates for low credit Business applicants

 Pay for what you use.                                       |     Potential temptation and Extra Charges and Fees

 Low credit applicants can be approved.  |     Collateral may be needed to secure the BLC

 Can builds business credit.                            |      Difficult to Qualify For

How to qualify for a business line of credit?

According to the SBA, a business line of credit requires financial statements, business and personal tax returns, bank account information, business documents, and more. You’ll also undergo a yearly review to maintain your line of credit. In the most cases, you’ll need two years of business history to qualify for a line of credit.

Most traditional lenders, such as banks, require businesses to have strong revenue and at least a few years of history to qualify for a line of credit. Larger lines of credit may require collateral, which can be seized by the lender if you fail to make payments.

The U.S. Small Business Administration estimates that 50 percent of all new businesses fail within their first five years of operation. As a result, a small business is typically required to prove a financial history of two or more years to qualify for a line of credit. Financial institutions require this to mitigate the risks associated with lending to start-up and fly-by-night organizations. Proof of financial history can be demonstrated by presenting a collection of banking and other financial statements. Small businesses may also provide income tax returns to prove their longevity. Regardless of which method is used, all information provided to the financial institution must be accurate.

There are some general rules of thumb you can use to determine the size of the credit line your business can reasonably maintain.

Before opening a business line of credit, it would be useful to compare the rates and fees of different financial organizations to reduce the overall cost.

After opening your business line of credit, the business owner or the person in charge need to take care on managing this funds by deciding how much the business really need, when, why, and how will be the repayment; If you’re not careful, you could end up borrowing more than you actually planned and find yourself saddled with a pretty hefty loan when payback time comes.

Business owners make extensive use of this method of financing to meet a cash flow need to meet unforeseen expenses; this is where some business gets to play Goldilocks: You don’t want a credit line that’s too large or too small—you want it to be just right. What “just right” means varies with each business, of course, as Mr. Marcus Mavakala, CEO (Peach Capital CO) mentioned in “Business line of credit vs Credit card” video, while he was talking about the 5 C’s of credit, a business typically needs to have $1.25 of income to support every $1 of debt service. You need to be confident that using a large amount of money from your business line of credit, your business will be able to readily absorb the resulting debt.

Here are the 5 Cs plus 1 to be considered when applying for a business line of credit

Capacity _ Does your business have the financial capacity to support debt and expenses? Typically a business needs to have $1.25 of income to support every $1 of debt service. The extra $0.25 provides a cushion for your business to absorb unexpected expenses or a downturn in the economy.

Character _ Work experience, experience in your industry and personal credit history are all character traits banks will consider. Your personal integrity and good standing—and the integrity and standing of those closely tied to the success of the business—are critically important.

Capital _ Your business owns capital assets such as cash and equipment; is there enough to help support the financing you want? You and others may have invested capital in your business; how much? The answer can be the master key of whether the business is one in which the bank wants to invest

Collateral _ Accounts receivable, inventory, cash, equipment and commercial real estate are all forms of collateral that banks leverage to secure loans. In addition to looking at the value of your collateral, the bank will consider any existing debt you may still owe on that collateral.

Conditions_ The state of the economy, trends in your industry and pending legislation relative to your business are all conditions that are considered by banks. These types of factors—often out of your control—may affect your ability to make payments.

Plus one more _ In addition to the above 5 Cs, there’s one more C that can make a world of difference: communication. As I said before, your willingness to communicate openly with your banker and your other adviser about the opportunities and challenges your business faces can be the key to a productive financial partnership.

Last advice

Studies show that it’s very seductive to most business owners, the use of the business line of credit for office renovation or a vacation of their dreams. Remember that the usual caveats to business owners apply about not borrowing for own consumption items — like vacations or anniversary gift — and understanding that the success of your business is always based on the business owner financial behaviors.

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