Is a business line of credit the best loan choice for your small business?

In May 7, 2018

Header image: Is a business LOC the best loan choice for your small business?A business line of credit (LOC) is a familiar loan that’s appealing to many because of its flexibility. It can be easily misunderstood, however, so understanding its nuances are important.

A discussion with a lender will often determine whether or not it’s the best solution for a borrower’s needs. Other loan products are often better suited.

What is a business LOC?

While there are several different types of LOCs, the most common is the revolving line of credit. It’s so common it’s become ubiquitous for the term.

Intended to be a flexible bridge loan to meet short-term borrowing needs when there’s a gap in cash flow, the revolving line of credit is specifically designed to not carry a balance. Payments are usually limited to interest-only minimums to ease the payment burden while operating cash reserves are low.

“A revolving line of credit is best used to fund the shortfalls in cash flow for a short period of time while the business converts sales to accounts receivables, and ultimately cash to pay down or ‘rest’ the loan,” says Mark Martinez, chief credit officer at Horizon Community Bank. “It shouldn’t carry a balance for very long.”

For many lenders, including Horizon Community Bank, the requirement that the LOC “rest” without a balance for a minimum of thirty days is built into the loan agreement terms. That mandated period helps businesses avoid turning their LOC into an overly expensive evergreen loan that’s never paid down, which can result in the loan’s not being approved for renewal.

It can also put a cash flow strain on businesses who use the LOC to carry a large balance, since they’re financing something that should be spread out over longer periods of time to reduce the payments. They’d be more likely to benefit from a long-term loan with fixed interest for financing large dollar amounts.

Learn more: Understanding business line of credit loans

Here’s what a business LOC is not

While most people think of it as a general loan fund for all and all borrowing needs, this is not how a line of credit should be used.

Can you use it this way? Certainly, because it’s a flexible credit facility to be used at the borrower’s discretion, but you’ll pay more for certain types of funding in the long run using a LOC than you would for another type of loan. You may have larger payments, a variable interest rate and less time to pay it off.

This can be problematic for cash flow.

Easy isn’t always best.

The flexibility of a line of credit makes it a very popular choice, but the best business loan isn’t always the one with the most convenient application process or the easiest to use. It may not even have the lowest interest.

For example, a SBA loan or conventional bank loan may have a more complicated approval process and take weeks or months to obtain, but it’s also likely to offer much better terms as a reward for that extra effort. Between the longer term with reduced payments and lower interest rates, you could easily save tens of thousands of dollars over the life of the loan… which puts extra cash in your pocket each month.

It also releases the business from the lender’s expectation of a resting period, since it isn’t a revolving LOC.

This difference in cash flow can make a powerful difference in the success of a business.

Secured or unsecured lines of credit may be available

Some revolving business lines of credit may be extended on an unsecured basis without collateral; however, this is the exception rather than the rule.

In most cases, a business line of credit is collateralized by working capital assets, such as accounts receivables or inventory.

What is a business LOC most suitable for?

Here’s the thing about lines of credit: they’re meant to be a fast solution to a temporary financial need, then quickly paid off to keep funds available when needed again.

Prepayment for seasonal merchandise to fill the gap until it generates revenue, sudden availability of used equipment that’s hard to find, temporary payroll shortfalls… these are common cash flow situations that can be simplified with a business line of credit. It fills the financial need for a few days or weeks, without carrying a balance for any length of time.

A line of credit can sit for months with zero balance and nothing due, then have a purchase trigger payments. Payments are flexible based on LOCs interest rate and/or the amount owed. The borrower is free to pay a larger monthly amount if they’d like to pay it off quickly, then reduce the payment to the minimum required if their cash flow changes.

Learn more: 5 smart ways to manage cash flow using a business line of credit

It’s similar to a credit card, but typically with lower interest and higher credit limits than a card can offer. It also does not have the cash advance fees that a credit card requires.

This is very different from a term loan, which has a set monthly payment for a specific length of time. This helps match the length of the loan to its purpose, to ensure payments don’t last beyond when the initial purchase needs to be replaced.

Smart business owners use strategic custom financing to match the loan to their need, rather than using a “one size fits all” approach of using a line of credit for all financial needs. Plunging into a line of credit without understanding the options available can negatively impact the cash flow of the business and expose it to unnecessary stresses and risks.

If you’d like to learn more about a business line of credit, or discuss different types of loans available and your specific needs, speaking to your banker can be immensely helpful.

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