Pros and cons of a business line of credit

According to the Federal Reserve Banks’ 2023 Small Business Credit Survey, 43 percent of small businesses who applied for financing sought out a business line of credit, while only 36 percent opted for a business loan.

A business line of credit is operates like a credit card, making it a flexible options for businesses. You can withdraw funds as needed to cover unexpected or higher short-term expenses, fill cash flow voids or keep operations running smoothly. Similar to a credit card, you’ll only pay interest on the amount you use, and you’re free to re-use the funds as you pay down the principal balance.

There are two types of business lines of credit: secured and unsecured. A secured line of credit requires some form of collateral, and you’ll typically get a better interest rate and attractive loan terms if you choose this option. An unsecured line of credit isn’t backed by any collateral and may come with higher interest rates than a secured line.

Before applying, here are some pros and cons of a business line of credit to keep in mind.

Business line of credit pros

Business lines of credit come with many key advantages that make them worth considering.

Improved cash flow

Past-due invoices and seasonal downturns often lead to cash flow issues in businesses. If you’re experiencing either or are dealing with an unexpected expense, it can be challenging to pay bills, take care of your employees and make investments in your business.

A business line of credit helps improve cash flow by giving you a pool of funds to pull from whenever you face these situations. So you won’t have to pause operations or shut your doors for good.

Accessible

If you were denied a bank loan, it’s likely due to your credit rating, time in business or annual income. However, you could have better luck with a business line of credit, even if you’re a startup or have bad credit, as some lenders have more lenient eligibility requirements.

For example, Credibly business loans offer secured and unsecured lines of credit of up to $300,000 to small business owners with credit scores as low as 600 and who’ve been in business for just six months.

Build a relationship with the lender

A business line of credit is an effective way to build a relationship with the lender. You’ll have the opportunity to demonstrate you can responsibly manage credit. Doing so could lead to credit line increases or make it easier to renew the line when the draw period ends. It may also help to get a business checking account with the same lender so they can see your cash flow, and you’ll earn trust.  

The lender may also be more lenient the next time you apply for business funding. Or you may qualify for better terms and lower interest rates.

May help build business credit

If the lender reports account activity to the business credit bureaus, you could build business credit with a business line. As your business credit score improves, you could access more funding opportunities and better financing terms.

Business line of credit cons

Despite their flexibility, business lines of credit also come with their fair share of drawbacks.

Fees

Business lines of credit may come with a number of loan fees to watch out for. These fees may drive up the overall cost of a business line of credit:

• Origination fee: Some lenders charge an origination fee when you take out a business line of credit. Some lenders may charge a flat fee, or you may have to pay a percentage of your total loan cost. This could be as low as 0.5 percent but can jump as high as 5 percent or more.
• Monthly maintenance fee: You may be subject to a fee incurred each month the business line of credit is open.
• Annual fee: Like a monthly maintenance fee, an annual fee may also apply each year the line remains open.
• Draw fee: You could pay a draw fee each time you withdraw from your credit line.
• Wire transfer fee: This fee may apply if you initiate a wire transfer to draw funds.
• Payment processing fee: Online payments come with a processing fee with some lenders.
• Late fee: You may be charged a late fee if you remit payment past the due date (unless a grace period applies).
• Early repayment penalty: Some lenders assess a penalty if you repay the lender before the term ends.

Higher rates

Interest rates on business lines of credit tend to be higher compared to traditional business loans.

You’ll generally qualify for competitive terms on a business line of credit if you meet the lender’s eligibility criteria and have a solid credit rating. But online lenders tend to charge higher rates compared to lines of credit from traditional banks and credit unions.

On average, business lines of credit have APRs ranging from 8 percent to 60 percent or higher.  Based on data from the Q4 2023 Small Business Lending Survey, the average rates for new lines of credit were 7.67 percent to 9.13 percent, depending on whether it was a variable- or fixed-rate line of credit at a rural or urban bank. By comparison, the average rates for new term loans ranged from 7.98 percent to 8.86 percent.

May have short repayment terms

For many business lines of credit, you can only pull funds from a business line of credit during the draw period. Once it ends, the amount you owe is converted to a loan and payable over a set period. The loan term may be brief, depending on the lender, essentially turning your line of credit into a short-term loan. Online lenders often have the shortest repayment periods, anywhere from 12 weeks to 24 months.

May not help build credit

Some online lenders do not report to the credit bureaus. So, making timely payments on your business line may not boost your personal or business credit rating.

How to determine if a business line of credit is right for you

A business line of credit may be the right choice for you if you fall into one or more of these situations:

• You need funding that you can access whenever needed
• You have short-term gaps in your cash flow
• You need a low loan amount
• You can pay back funds quickly
• You can adequately manage the line of credit, including whether loan repayments fit into your current budget

Alternatives to a business line of credit

If a business line of credit isn’t the right fit for your company, there are alternatives to consider.

Term loans

Business term loans are a popular funding option offered by banks and online lenders. You’ll receive the funds in a lump sum and repay the balance in equal monthly installments over time. Most term loans come with repayment periods of five or more years.

Some lenders have stringent time in business, credit score and annual revenue guidelines that can make it challenging to get approved. You also may not be eligible for the best rates, especially if you have poor credit or are a startup business.

Invoice factoring

Invoice factoring involves selling your unpaid invoices for cash. Most factoring companies offer up to 85 percent of the invoice value. They also assume responsibility for collecting what’s owed. Once the invoice is paid, you’ll receive the remaining balance minus any applicable fees.

This funding alternative is ideal if you need fast cash, but the fees are usually higher, depending on how long it takes customers to take care of the invoices.

Invoice financing

With invoice financing, you can get an advance of up to 85 percent on your accounts receivable — or unpaid invoices. When you receive payment, you’ll repay the amount advanced and any applicable fees to the financing company. Like invoice factoring, you’ll have to watch out for high rates and fees.

Merchant cash advances

Merchant cash advances (MCAs) are more easily accessible than business lines of credit and traditional business bank loans. They’re typically one of the easiest bad credit business loan options available. Instead of assessing your credit score, revenue and time in business, the lender evaluates your credit card sales to determine your eligibility for funding.

If approved, you’ll receive a lump sum, typically payable in a year or less, through a percentage of daily credit card sales. Despite its convenience, this funding solution also comes with steep fees based on a factor rate.

And since these are cash advances and not loans, MCAs are not subject to usury laws, which protect people from being charged excessive interest charges. In some cases, it’s possible to get stuck with triple-digit APRs. So, a merchant cash advance should only be used to meet a short-term funding need that can be paid back quickly.

Crowdfunding

You can steer clear of financing to start or grow your business with crowdfunding. It requires you to raise funds in exchange for a percentage of your company’s equity or some other incentive. Crowdfunding is an ideal way to avoid all the red tape of applying for a business line of credit or other forms of business financing. Plus, you can garner increased exposure for your business.

Still, you’ll likely commit a lot of time to the project and risk your idea being stolen. There’s also a fee to use crowdfunding platforms, and you’ll typically be required to return donations if you don’t meet your fundraising goals.

Business credit cards

Business credit cards are another possible funding source for your company. If you have good credit, they generally come with generous spending limits. And some offer sign-up bonuses and interest-free introductory periods. Plus, you can easily track business spending, access employee cards and take advantage of business-related perks and discounts.

But there’s a significant downside. Business credit cards are not covered under the Credit CARD Act of 2009, which comes with a host of consumer protections, including the mandatory disclosure of interest rate increases. Plus, you risk creating a mountain of debt if you can only make the minimum payment for an extended period.

Bottom line

The best business lines of credit come with several benefits, making them an attractive option for new and established companies. But there are also downsides to consider before applying for funding. An alternative could be more viable depending on your company’s financial status and unique needs.

Frequently asked questions

• When is a business line of credit a good idea?

  A business line of credit is best if you want a flexible solution to cover short-term cash-flow gaps. If you need a large sum of cash or a long period of time to pay off your debt, a term loan would be a better option.

• Is it hard to get a business line of credit?

  It depends on the lender and your creditworthiness. Each lender has a set of eligibility criteria that includes a minimum credit score, time in business and annual revenue threshold. If you meet these guidelines, you could be eligible for funding.

• What credit score do you need for a business line of credit?

  Some lenders accept small business owners with credit scores as low as the mid-500s. Remember, the best terms on business lines of credit are usually reserved for the most creditworthy borrower. So, it’s worth improving your credit score before applying if it’s on the lower end to minimize borrowing costs.