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If you are looking for short term credit for your business, a business line of credit can work wonders. A line of credit is different from short term loans as you have the flexibility to withdraw funds as per your business needs and pay interest based on the funding availed. Similar to how credit cards functions, line of credit is emerging as a preferred borrowing option for small and medium businesses as is quick, effective and can meet their immediate credit needs such as paying for payroll, meeting daily cash flow, purchasing raw materials, and more.
In this article we take a look at business line of credit meaning, how it works, how to get a line of credit with bad credit, the pros and cons of line of credit, and how startups can avail this funding option for their business.
What is a business line of credit?
A line of credit is an on-demand short term business finance option to meet immediate business needs. It is usually referred to as revolving, that is, you can use what you need, repay it, and borrow again. The borrowing limit is set by the lender and based on it, you can borrow funds when you need it. As can be understood, this type of business financing, is most suitable for emergency and unplanned expenses and can be availed quickly without going through the comparatively longer process of getting a business loan.
Example of line of credit: How does it work?
When you approach a lender, based on your business credit report and overall creditworthiness, the lender will approve a line of credit or funds withdrawal limit. You can keep borrowing from the pool based on your requirement, repay it in time, and borrow again. For instance,
Approved unsecured business line of credit: ₹2,00,000
Funds borrowed: ₹1,00,000 (interest paid will be on this sum i.e., the actual sum borrowed and not the entire credit amount approved)
Interest rate: 2.5% p.m. or up to 30% p.a. (interest rate is determined by the lender and mentioned in the contract along with repayment terms)
Repayment period: 1 month*
Total interest: ₹2,500
Total payable: ₹1, 02,500
*Repayment tenure depends on the lender. In most cases, you need to repay the entire debt within the repayment period to be eligible to borrow again. In some cases, they lender may allow you to make monthly repayments. This allows you to repay part of the principal and interest and reset your credit facility option.
Business loans vs Line of Credit (LoC)
It’s understandable for you to question at this point on the right source of business finance for you. Whether to opt for small business loans or a business line of credit loan. Here’s a snapshot for you to decide.
Small business loan vs line of credit
|Small business loan||Business line of credit|
|Term loans borrowed for a specific period of time. These can be closed before the tenure against business loan foreclosure charges.||Borrowed against draw period and to be repaid during the repayment period. They are revolving in that you can borrow, repay and borrow again.|
|Short or long term loans (up to 7+ years) borrowed to meet specific business needs, e.g., purchase machinery, working capital needs, business expansion, pay rent etc.||Short term funding options to meet emergency or unplanned financial needs.|
|Complete loan amount disbursed at one go.||Can be withdrawn as per business needs up to the limit approved by the lender.|
|Requires detailed documentation and paperwork for approval.||Based on the borrowers credit score, source of income, financial history and relationship with the bank/lending institution.|
|Interest charged on the entire loan amount, repaid as EMI over the entire tenure.||Interest charged on the funds actually availed and the repayment tenure.|
|Other fees and charges (e.g., processing fee, stamp duties, documentation charges, etc. are applicable).||Check with the lender as some may charge a minor fee for account activation or even inactivity if you haven’t availed the facility.|
Types of small business line of credit
In general, borrowers can avail secured or unsecured line of credit. Similar to business loans, a secured business line of credit requires the borrower to pledge an asset or security, while an unsecured business line of credit can be taken collateral-free. There may be however the need to have a personal guarantor.
A quick summary of the key highlights between secured vs unsecured business line of credit are:
- Collateral has to be offered for secured line of credit. Depending on the lender the collateral can be an asset, inventory, accounts receivable or any other. Since line of credit is a short term financing option, assets such as property or land is usually not pledged as security (to understand the concept, read about loans against property for businesses).
- Unsecured business line of credit is offered without any collateral. This is riskier for the lender as there’s risk of defaulting. In such cases, the borrower’s financial history, business’s P/L and revenue, credit score, and relationship with the bank is prioritised.
- As can be understood, unsecured line of credit comes with lower credit amount and higher interest rates than secured line of credit.
Advantages and disadvantages of line of credit for business
Should you go for a line of credit for your business or a business loan or any other funding option? This can be a crucial decision as it will impact future financial decisions for your business. Let’s look at the merits and demerits of business line of credit.
Business line of credit pros and cons
|Advantages of LOC||Disadvantages of LOC|
|Flexibility to withdraw partial or full funding when you need it.||Not offered by all banks or financial institutions. Check with lenders specifically for LOC finance.|
|Ease to use funds as per business requirements.||Leads to debt accumulation if you do not have financial discipline.|
|Interest is paid on the portion of funds availed and as per the tenure of borrowing.||Can come with specific charges and fees (e.g., account maintenance charges, late payment fees, application charges etc.). Interest rates vary making it difficult to plan financial expenses.|
|Can help to increase CIBIL score (credit score) when you repay funds as scheduled.||Unsecured LOC can only be availed for small amounts.|
|Revolving or cyclic in nature, i.e., you can borrow as per your limit, repay the funds, and borrow again.||Can impact credit score and interest paid if debt is not cleared on time or if there are frequent withdrawals.|
Can you use business line of credit for personal expenses?
A line of credit can be borrowed for personal expenses. However, when a line of credit is borrowed for business purposes, it should be spent in meeting emergency or specific business expenses only. In most cases, to avail personal line of credit, an individual must have an account with the bank. These credit options are usually collateral-free.
Startup business line of credit
As a startup business, it’s likely that you will need access to immediate funds to meet specific business growth needs. A line of credit can be a good option to consider. It can be set up with 5 business days, requires no collateral, and you can pay interest on what you avail. However, considering that startup businesses often don’t have enough financial history or business revenue to showcase, the credit option offered can be limited.
Always re-check these business line of credit qualifications before application:
- Credit score – usually 650+
- Business vintage – 12+ months usually
- Specific monthly or annual revenue – e.g., ₹5+ lakh/annum
- All financial statements (6+ months), ITR, balance sheets, P/L statements
How to get a startup business line of credit with bad credit?
If you are a startup business with bad credit score, it can be difficult to get a line of credit. Most lenders consider 650+ as the minimum credit score for loans. As such, if your business and/or personal credit score is lower than that, there are lesser chances of getting better deals on your business line of credit.
In some cases, you may need to be an existing customer of the bank with a current account for your business with the bank. Other factors to keep in mind are:
- You may have to pay higher interest rates and not be eligible for low interest business line of credit
- You may have to offer some form of collateral as security
- You may need a co-borrower or a guarantor on your application
- You may also have to share a business plan and/or a project report that will explain how you intend to spend the funds and the returns you expect from it
Alternatively, you can apply for Business Loans through Tata nexarc. We have partnered with leading providers and offer unsecured business loans up to ₹50 lakhs. These are low interest rate loans, with minimum documentation and quick disbursal. Apply now.
Starting a business line of credit – To opt or not
Your credit score or creditworthiness is going to impact your ability to avail a line of credit. So, if you have bad credit scores, then consider improving these factors that impact CIBIL score before proceeding.
A line of credit in the end is a form of financing for business. Whether you opt for it for go for any other type of business finance depends on your needs, finances, and future trajectory. For instance, if you need to buy an equipment, then equipment financing is a more suitable option. However, if you need funds to immediately buy inventory for unexpected sales, a business line of credit is favourable.
Evaluate your options, seek advice, discuss with financial experts and make the right choice based on information available and what works best for you.
(Note: This article is for information only. Readers are requested to connect with lenders directly for more details on business line of credit.)