A business line of credit can be very effective in funding the growth of your small business or in riding through uneven cash flow periods. However, a business line of credit (LOC) is not for everyone and should not be entered lightly.
A business line of credit is often referred to as a revolving line of credit. It is an amount of money that you can draw from to pay business expenses. Funding for lines of credit comes from several sources. In the past, lines of credit were typically funded by banks and were used to support short-term funding needs, like accounts receivable. However, the landscape has changed, and there are a number of alternative funding sources that businesses can turn to for lines of credit.
A line of credit is not like a loan in that you only pay interest on the amount you use, not on the entire line. So, for example, if you have a $100,000.00 line of credit and use $10,000.00 to buy materials for an upcoming job, you only pay the interest on the $10,000.00 for as long as you have the $10,000 outstanding. So, if you pay the funds back in 3 months, you will pay interest only for 3 months on $10,000.
Lines of credit stay open and are available for the business to use at their discretion, up to the limit of the LOC. For example, if you have a $100,000 LOC, you can borrow up to $100,000 at any time. However, many lines of credit require the business to “clean up” the line for 30 days. This means that the business must have 30 consecutive days sometime through a 12 month period, where they have $0 outstanding on the LOC. Each year, the LOC is reviewed by the funding source to determine if the line is still required and for how much.
Lines of credit are used for short-term funding needs and are designed to help a business fund short-term requirements, like inventory and receivables. This differs from loans that are used for longer-term funding requirements, like purchasing equipment.
A small business line of credit is typically secured by some asset(s) of the business. In many cases, all of the business assets are used to secure the LOC, even if the line is there for funding one of the businesses. Lenders want to be sure the line is collateralized by enough assets to ensure that the debt can be collected. Depending on the amount, you may be required to secure your line of credit with a blanket lien via a UCC-1 Financing Statement. Contact your attorney for legal advice before signing any legal documents, including a UCC-1. The secured line of credit requires the commitment of collateral. Collateral can be inventory, accounts receivables, or securities. In the event of a default, the creditor can seize your assets to satisfy the debt.
An unsecured line of credit means you don’t need to put up collateral in the event you default, which is very uncommon in business lending.
A blanket lien is a lien that gives the right to seize, in the event of nonpayment, all types of assets serving as collateral owned by a debtor. Theoretically, a blanket lien provides a creditor with a legal interest in all of the debtor’s assets serving as collateral.
Blanket liens provide maximum protection to lenders but minimum protection to borrowers. Borrowers can potentially lose all of their pledged assets if they default on debt subject to a blanket lien.
A line of credit provides funds to a business that can be accessed at any time and paid off as the funds become available to the company.
A loan is used for an expense or business purchase, or investment.
Always use a line of credit as needed and never purchase anything unrelated to your business. Understand the payments terms, interest, and make extra payments if you are able. Always consult your CPA or financial advisor before obtaining a line of credit.
Investopedia cautions, Some banks will charge a maintenance fee (either monthly or annually) if you do not use the line of credit, and interest starts accumulating as soon as money is borrowed. Because lines of credit can be drawn on and repaid on an unscheduled basis, some borrowers may find the interest calculations for lines of credit more complicated and be surprised at what they end up paying in interest.
Paying back a line of credit consists of 2 types of payments, the principal, and the interest. Be sure to plan for the repayment of the principal as soon as the need no longer exists. This requires a bit of planning and discipline but is critical. A word of caution here…Far too many businesses fall into a situation where they believe they have more cash than they do and use the funds for things like payroll. This can create a challenging problem to correct. Lines of credit are a great source of funding but need to be used carefully and with a defined plan for paying back the principal.
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This blog post and content on our website are for informational purposes only and are not intended to give legal or financial advice. Therefore, it is best to engage the services of an attorney or financial professional.