A line of credit is the most sought offer financing option for business owners. Why? The flexibility they provide is unparalleled. Whereas your typical term loan will give you one lump sum of cash to use -- and to pay back over time -- a line of credit is more like a reserve pool of a set amount. You can draw capital up to that maximum when you need, and you’ll only pay interest on what you withdraw. Plus, as soon as you pay back what you owe, you’ll have the maximum at your disposal again. In short, it is a safety net for your business. And unlike what we usually think of as revolving credit -- business credit cards -- a line of credit allows your business to have access to cash and often at lower rates than credit cards.
But the line of credit has gotten a makeover in recent years. It is no longer just the bank down the street handing them out. Here are four completely different lines of credit your small business needs to know about.
Related: Five ways to build business credit.
1. Traditional line of credit.
The traditional line of credit is typically meant for experienced business owners with proven business models. Which makes sense since the credit maximums are sizable, the rates are lower, and the requirements demand higher credit scores and annual revenue reporting. More often than not, these come from the bank where you house your business bank account.
Compared to a term loan of similar size, a line of credit might have a lower interest rate and closing cost -- but it will likely also come with a substantial interest rate hike if you overdraw your account or fail to repay what you’ve withdrawn.
If you’re a business owner taking out a line of credit, you’ll be spending that flexible cash on seasonal business expenses, payroll and other operational costs, insurance against emergencies and for sudden opportunities. In other words, as a capital cushion. It’s there for you when you need it.
2. Short-term line of credit.
The difference between a short-term line of credit and a traditional line of credit is more or less the same as the difference between your typical short-term loan (think loans offered by an OnDeck or CAN Capital) and conventional bank or longer-term online loan (think loans offered by a Lending Club or Funding Circle). Therefore, a short-term line of credit has a higher interest rate, lower credit maximum, faster turnaround time and looser application requirements.
Unlike the traditional line of credit, the short-term line of credit is generally offered by alternative lenders rather than by banks. The point isn’t that one is better or worse -- they appeal to different groups of business owners.
Those with lower credit scores, smaller annual revenues, or newer businesses might only qualify for a short-term line of credit. And although the short-term line of credit tends to be more expensive, its value lies in giving younger small businesses the opportunity to maintain a flexible pool of capital.
3. Equipment-backed line of credit.
Beyond short-term and traditional lines of credit, small business owners can also look into lines of credit backed by certain kinds of collateral. In this case, we’re talking a line of credit secured by business equipment.
Here’s how it works: asset-based lenders care more about your future prospects than they do about your past borrowing history (or at least they care nearly as much about the two). You get some necessary equipment -- a vehicle, new exercise machines, a printing press -- and that equipment-backed line of credit lender will hand you a line of credit based on the value of your equipment.
The good news is that these lines of credit tend to have more relaxed requirements even if their maximums and interest rates don’t dip -- but at the cost of a lien, or claim of ownership in case of loan default, on that shiny new equipment. They’re relying on the value of your equipment or inventory, instead of on your borrowing history, to feel confident about your loan.
4. Invoice-backed line of credit.
The basic idea behind invoice financing (also called accounts receivable financing) is that, sometimes, customers take a long time to pay you back -- but you might not be able to wait. Instead of relying on short-term loans to cover operating costs, or digging into your savings, you could just get those invoices paid right away -- although you’ll have to shoulder the costs of that speed and efficiency.
An invoice-backed line of credit follows the same logic. The value of your invoices determines your credit maximum, and you can draw capital as needed instead of relying on your customers to pay on time. And as your invoices increase, you’ll typically have access to more cash from the line of credit as well.
If you’re a small business owner thinking of growing your opportunities or easing your cash flow problems, one of these lines of credit might be right for you. Whether it’s a standalone product or a supplementary source of capital, a line of credit is a great safety net for your business.