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What is a Line of Credit? Uses + Pros & Cons

Introduction

A company will inevitably run into cash flow issues from time to time. Sales growth is never smooth and can come in fits and starts. These discrepancies are difficult to control, and they frequently leave you cash-strapped, unable to pay suppliers or workers or expand. When a firm runs into cash flow issues, most owners will seek a business line of credit. A business line of credit is the most similar to a business credit card among the financial products you're undoubtedly aware of.

You are given a maximum balance and can withdraw funds as needed. You make a minimum payment each month based on the loan's current balance. On the other hand, a business loan operates similarly to a mortgage or auto loan: a bank gives you a lump sum, and you make monthly payments until it's paid off. With quick access to a mortgage's maximum and no further approvals required, a line of credit may be a very tempting concept. It may simplify commercial equipment investment and acquisition when used correctly, but it can also mean disaster for unprepared people.


line of credit

Uses of a line of credit

In general, lines of credit aren't meant to be used to pay one-time purchases like houses or cars—what that's mortgages and vehicle loans are for—but they may be used to purchase goods that a bank might not typically qualify a loan for. Individual line of credit is most often used for the same purpose as company lines of credit: to smooth out the peaks and valleys of fluctuating monthly income and spending or to fund projects when exact funding requirements are impossible to predict in advance.

Lines of credit can be beneficial in circumstances where there will be frequent financial outlays but the amounts aren't known ahead of time. The merchants don't take credit cards and instances requiring significant cash deposits—weddings are a notable example. During the housing boom, a line of credit was frequently used to pay for home remodelling or restoration projects. The most common purpose for establishing a company line of credit is to get short-term finance.

Most firms utilise this money to help finance operating costs like supplies and salaries, and inventory expansion. Off-season operating capital is frequently accessed through an unsecured line of credit by cyclical enterprises. Unlike many small company loans, an unsecured line of credit is not tied to a specific purpose or purchase; it's an excellent option for small firms wanting to manage cash flow better. A business bank account, a small company credit card, or even a Mobile Banking app are commonly used to access funds from a line of credit.

Advantages of a line of credit

Keep in mind that your bank will want to review your company's whole credit history before considering extending a line of credit. If that isn't enough to persuade you, consider the following benefits of a LOC:

  1. The relationship you develop with the lender is one of the most rewarding elements of obtaining a line of credit. In addition, this might benefit you in the future if you need more funding for other initiatives.

  2. Businesses that utilise their lines of credit carefully and deliberately may see their credit rating improve, which may be beneficial when applying for other loans and credit lines.

  3. Unlike a loan for equipment or office space that your company could take out, lines of credit don't necessarily need you to present a rationale for the borrowing. Furthermore, the money in a LOC is available whenever you need them and are not required to be utilised.

  4. A line of credit can be processed in as little as 24 hours, compared to other forms of credit. A line of credit generally takes a few days to process, even for bigger credit lines. It might take up to two weeks from the commencement of the application procedure for a credit card. If you use a home equity line of credit to supplement your income, you may have to wait several months for the funds to become available.

  5. The availability of credit on a credit card, along with its convenience of use at the point of sale, makes it a temptation for consumers to buy things they don't need. From a company standpoint, using a credit card might result in tax benefits, leading to more purchases. A line of credit is generally connected to a bank account, which helps most people avoid impulsive purchases.

  6. A "draw" option is the most typical arrangement for a new line of credit. It works in much the same way as a credit card, allowing you to spend money as needed while making a regular monthly payment. The monthly payment will stop after you have paid off the whole balance. “Demand” is a different choice. You'd still be able to use the line of credit as before, but the lender may demand full repayment at any moment. A "balloon" payment is the third option. A big payment would be needed after the period, although smaller monthly instalments would be permitted.

Disadvantages of a line of credit

  1. When you apply for a line of credit, you'll notice that the interest rates, the maximum amount you may borrow, and other aspects of the loan will all be different. As a result, you’re forced to shop around with a few other lenders to see what type of discounts you can get. That implies that each application you submit results in a tough credit draw, which might harm your credit score if you have a lot of them.

  2. A line of credit may not offer the same level of spending temptation as a credit card, but it doesn't mean the temptation isn't there. A line of credit may not be the best option for those who have trouble controlling their spending and frequently max out their personal or corporate credit cards. You could end up maxing up another credit account, leaving you with even more debt to deal with in the future.

  3. When you elect to use a line of credit, interest will start accruing on the amount you use right away. The outstanding balance on the line of credit is then charged interest until the withdrawal is fully repaid.

  4. When opposed to a line of credit, credit cards are more strictly regulated. When you create a new account, make sure to double-check all of the costs that may be imposed. In addition, you must check to determine if any penalties may apply. For example, going over your credit limit, making a late payment, or not using your credit line may incur extra fees. Another location where you'll need to spend a lot of time comparison shopping to make sure you're getting a reasonable price is at the grocery store.

  5. A credit score of at least 690 is required for most new lines of credit. However, you may be required to have a credit score of 750 or better by some institutions. With few collection efforts and bad public records, you’ll also need a solid credit history dating back at least 5-7 years. You must also submit proof of employment and, in the case of self-employed persons, tax paperwork for several years. To be accepted for a business credit line, the same conditions apply, including continuous verification of sales.

Conclusion

A business line of credit can be helpful at any stage of your company's development. However, before making a selection, make sure you grasp the advantages and disadvantages. It might be one of the greatest financial instruments at your disposal if you need a reliable approach to enhance your company's creditworthiness and you completely grasp the hazards.


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