How Does a Business Line of Credit Work?

Typically, a business line of credit is defined as an agreement between a financial institution like a bank and a business that allows them to withdraw money against …

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Typically, a business line of credit is defined as an agreement between a financial institution like a bank and a business that allows them to withdraw money against a loan whenever they need it, as long as they don’t exceed the loan maximum. That definition sounds a bit technical though, so here is what it really means to you.

Like a Credit Card Without the Card

A business line of credit is kind of like a home equity line of credit: you have a limit on what you can spend. You can pay it off as slow or fast as you need to, but there is usually a minimum payment required.

The key to this type of loan is that you don’t get the whole loan amount at one time. Instead, you use it like a credit card: you can take out up to the amount you are offered, but you don’t have to. The more you use, the higher your payments. The loan is secured by the potential income of your business, which is what the bank (and you) are counting on.

Sometimes the line of credit account will come with its own debit-style card, but unlike a business credit card, it is considered “secured.”

Smoothing Out Budgets

What a business usually uses a line of credit for is to smooth out budget spikes. You might have payroll expenses one week, and money from invoices you have already created coming in the next week. So, you “borrow” the payroll money you need from the account and replace it the next week with the invoice money you receive, keeping the account balance on your line of credit low.

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You also may need to hire extra sales people for a spike in business or purchase new equipment to complete a project or begin a new aspect of your business. The business line of credit allows you to do that, and then to pay it back as you make the money you have spent.

Working Capital

A common term for this type of money is working capital. If you have the money in the bank and can smooth things out yourself when you have spikes, that is ideal. However, many small businesses and startups benefit from a business line of credit because it allows them to do work they would otherwise have to put off.

A business line of credit allows them to have the flexibility of working capital until they get to the point where they have the funding in the bank and no longer need credit to smooth out those spikes in expenses.

Still, many businesses use a line of credit for working capital so they can invest profits into company growth even when they are more fiscally healthy. A business line of credit also boosts your company’s credit rating.

Using a Business Line of Credit Wisely

There is a certain risk to using a business line of credit. It can lead you to debt and maxing it out frequently means you might not have the funding you need at a critical time.

Also, financial institutions like to see that your line of credit reaches a zero balance frequently throughout the year, which shows your business is making a profit and using the funding wisely. Even if you only pay it off for a few days, try to reach a zero balance on your business line of credit frequently.

The most common uses for a business line of credit are ones all businesses can relate to:

  • Tax Season: Even if you have a tax savings account and have paid your quarterlies, growth and larger income means more taxes, and if you bill is higher than you expected, a business line of equity can help you pay those taxes promptly and keep yourself out of trouble.
  • Events and Conferences: one of the best ways to get more leads and get the word out about your business is events and conferences. However, materials and personnel for these conferences cost money. Your line of credit can help you cover those expenses.
  • Day to Day Operations: Let’s say a bill comes due to a vendor, or you need to pay employees, but you are waiting for client payment. Your business line of credit helps you pay those expenses.

You never know where your business will be three months or a year from now. A business line of credit lets you stay afloat at times when your income dips or you have a spike in expenditures of all types.

A business line of credit simply gives you options you might not otherwise have. You may need it very little, and you might not even need to use it most of the time. However, having a line of credit available for the situations where you might need it gives you a certain peace of mind you might not have otherwise.

Are you considering applying for a business line of credit? For what reasons would you use your new found source of funds? Leave us a comment in the section below.

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