A detailed guide to Line of Credit – understand the various types, compare and choose the right one in 2020
When individuals and small businesses borrow money, sometimes they borrow more than the required amount and end up not utilizing the funds effectively. It is often impossible to predict the exact amount one needs at a given point in time. In such scenarios a line of credit can come as a flexible loan option for individuals and small businesses alike. It is very important you understand the various options, terms and other details associated with a line of credit to help you choose wisely and use the funds effectively for maximum returns.
What is a Line of Credit (LOC)?
A line of credit is one where a financial institution (bank or non-bank lender) grants access to a preapproved amount of finance. The amount is available to you for a specified period of time and you can access the funds as and when you need it. Unlike term loans, a line of credit can be tapped into multiple times till the maximum limit. The interest is paid only on the utilised funds and the balance funds are available for use at a later time. Once you have a line of credit facility, you can draw any amount within the specified limit without any further approval from the lender.
How does a Line of Credit work?
So, how exactly does it work? Let us illustrate this with an example.
Assume you own a small business and have a good credit history. Often, you might need an influx of quick funds for cash flow or working capital. If you have a line of credit with a bank or a non-bank financial lender, a pre-approved amount is available to you to tap into when you need it. Based on your requirement, you can use only the required funds from the total pre-approved line of credit. The balance funds will be available to you as and when you need them. You only have to pay interest on the amount used and not the total amount available to you.
For instance, if the total approved line of credit is $50,000 and $25,000 is tapped into, access to the balance $25,000, if necessary, remains. If the utilized amount of $25,000 is paid back, there is access to the entire $50,000 without having to reapply, one of the biggest benefits of a line of credit.
This is very useful for small business owners since this gives you quick access to funds. You could use this for your regular cash flow needs, working capital, buying stock or even hiring temporary staff during a peak season. Probably one of the reasons this is a preferred small business loan option.
Types of Line of Credit
A Line of Credit can be unsecured or secured and revolving or non-revolving.
Unsecured vs. Secured Line of Credit
A line of credit can be unsecured or secured based on whether they are offered against your turnover or backed by a property. Most LOCs are unsecured with the exception of a home equity line of credit (HELOC), which is secured by the equity of the borrower against the property on which the loan is availed. Secured LOCs come with a lower interest rate and higher loan amounts since the lender has the backing of a property in case of a default in payment.
Unsecured lines of credit on the other hand, come with higher interest rates compared to secured ones. They are similar to a credit card and comes without any backing in case of a default. Hence, lenders tend to charge higher interest on the line of credit. An unsecured line of credit also demands a good credit history from the borrower and the line of credit extended is often lesser compared to secured LOCs.
Revolving vs. Non-Revolving Line of Credit
A revolving line of credit is one where a borrower can draw funds multiple times up to the maximum pre-approved line of credit offered. Based on repayments, the funds are available again for use by the borrower during the term the LOC is active. The interest is paid only on the funds used and the balance funds are available for use at a later time. This is particularly beneficial for small businesses since they can use the funds for cash flow or other similar needs on a continuous basis.
An example for revolving line of credit – Let us say a small business has been offered a line of credit of $10,000 for a 12-month period. If the business withdraws $2,000 in the first month, the balance $8,000 is available to be used at any point during the tenure of the LOC. The interest is paid only on the $2,000 and not on the entire amount of $10,000. The next month, the business can draw an additional $1,000 and the balance of $7,000 will be available for use at a later time. Let’s assume that at the end of the 2nd month, the business repays a sum of $1,500. The balance available now is $8,500. This way, the small business can use only the amount that is needed for the business and pay interest only on this amount and not the total amount of the loan.
A non-revolving line of credit is one where a pre-approved amount is available to an individual or a business similar to a revolving line of credit. The only difference is that once a portion of the loan amount is utilised, it doesn’t get replenished and only the balance funds from the pre-approved amount is available to be used during the term. Once the total amount is repaid, the line of credit is closed and cannot be used again.
Credit Lines also come in various forms based on the needs of the individual or business. These could be secured or unsecured and each lender will have different terms, interest rates and terms based on the requirements and internal policies. Some of the important ones are listed below.
Business Line of Credit
A business line of credit is provided for businesses purposes based on nature of business, average revenue, and previous credit history. The funds available with business line of credit is usually lower than other typical loans. Hence these funds are mostly used for immediate expenses like cash flow, working capital or for buying stock. Typically, business lines of credit are more suited for businesses that have been in business for longer, have a higher credit score and have a stable monthly turnover.
For a detailed understanding of Business Line of Credit, refer the section below on this page.
Personal Line of Credit
A personal line of credit is similar in nature as other line of credit options but is used for personal needs as the name suggests. This could be for a holiday, buying a new car or even your home renovation. Since the funds are available to you at your convenience, the rates for a line of credit might be slightly higher than regular unsecured or secured loans. A line of credit will come with establishment fee and monthly service fees. So it would be diligent to check the various terms associated with a personal line of credit before you secure one. Personal line of credit is mostly unsecured, and often requires the individual to have a healthy credit score and a history of repaying debts on time.
Home Equity Line of Credit
A Home Equity Line of Credit, also known as HELOC, is a secured LOC where the lender offers a pre-approved amount as Line of Credit for a specified time period (term). The collateral is the borrower’s equity in her/his house. HELOC differs from a conventional mortgage loan in that the total loan amount is not offered up front, but as a line of credit that can be tapped into multiple times till the maximum credit amount is reached. Repayment is on the drawn amount and interest on that amount only. Many home owners use a HELOC only for critical requirements such as a medical emergency, education or for home improvements. A Home Equity Line of Credit is often categorized as a second mortgage in the industry.
Advantages of a Line of Credit
- Flexible use of funds - Once approved, funds can be utilised based on your specific business needs.
- Use only the required amount - Unlike regular loans, you can use on the required amount from the available line of credit and the funds can be tapped into multiple times.
- Interest paid on the utilised amount only - You don't have to pay interest on the total line of credit, only on the funds used.
- Businesses with lower credit score can also qualify - Even if you have a lower credit score, you could gain access to a line of credit. The interest rates could be higher, but you will still have access to funds.
- Options available for new businesses - A secured line of credit can also be extended to relatively new businesses.
- No reapplication required - The best feature of a line of credit. Once approved, a line of credit can be tapped into multiple times without reapplying.
Limitations of a Line of Credit
While there are a lot of advantages associated with a Line of Credit, like any other loan product, it comes with its fair share of limitations. Some of the key ones are listed below.
- For starters, most lenders would require you to have a higher credit score to extend a Line of Credit.
- The interest rates are higher in most cases since Line of Credit is often unsecured. Moreover, the interest rates are mostly variable and can vary based on the lender and type of LOC.
- The total amount extended in an unsecured line of credit is often lower than an unsecured loan, especially for small businesses.
- There are heavy penalties for overspending and late repayments.
- Misuse of a line of credit or inability to repay can hurt your credit score and impact future borrowings.
Line of Credit vs Loan
So, what is the difference between a Line of Credit vs a loan? The key differentiators are outlined below for your understanding.
Line of Credit
A line of credit enables you to use only required funds from your pre-approved amount
A loan is usually a fixed amount that is lent to you.
Variable interest rates on the amount used from the LOC
Fixed interest rate for the period of the loan on the entire amount
Only smaller amounts available as LOC
Larger amounts available based on business turnover
Since there are different types of loans, a general perspective is shared above. This could vary based on the type of the loan, viz. Personal Loan, Business Loan or Home Equity Loan.
Business Line of Credit
A detailed guide for small business owners to a business line of credit in 2020.
A business line of credit, as mentioned earlier, is provided for businesses purposes based on nature of business, average revenue, and credit history. But not all businesses qualify for a line of credit. In this section, we have tried to address key questions pertaining to eligibility, how to secure a line of credit for your business, what can small businesses use these funds for and how to choose the right lender for your line of credit.
Eligibility criteria for a Business Line of Credit?
In order to qualify for a line of credit, small businesses need to fulfil the following criteria set out by banks and non-bank lenders. Once these conditions are met, any small business is eligible to apply for a line of credit.
- Australian business with active ABN
- Average monthly turnover of at least 6K per month
- Trading for minimum 6 months
- A profitable business
Any business that needs a continuous influx of funds and meet the above-mentioned qualification criteria qualify for a business line of credit. Listed below are some scenarios to understand the qualification criteria better.
- Businesses that want flexible funding solutions
- Small businesses looking for quick funding options
- Businesses without any assets and collaterals to avail secured loans
How do I get a line of credit for my business?
If you meet the eligibility criteria mentioned above, your business can qualify for a line of credit. As a small business, you can avail a line of credit from your bank or a non-bank lender. Most banks usually provide secured line of credit while non-bank lenders offer unsecured line of credits. Of course, the interest rates are higher for an unsecured line of credit, but then you also don’t have to risk a collateral or property to secure a line of credit from non-bank lenders.
Looking for a line of credit? Get in touch with the team at Capital Boost and we will find the right lender based on your requirements.
What can I use a business line of credit for?
A business line of credit can be practically used for any business purpose. Most small businesses use a line of credit to manage regular cash flow needs. This could be for paying wages to employees, procuring additional stock during a peak season, paying suppliers or covering unpaid invoices.
A line of credit can also be used for introducing new product lines, marketing your brand or opening new outlets (in the case of retail businesses). It does not matter what you use a line of credit for as long as the purpose is associated with your business.
How to choose the right lender for a business Line of Credit?
With the various options available in the market, and each lender having varying payment terms and interest rates, it often gets confusing for small business owners to choose a line of credit suited to their needs. Choosing a lender should depend on your requirement in terms of funds, while ensuring that you get the best rates and terms associated with the LOC. A good understanding of the fees and pre-closure terms associated with the line of credit is also essential to avoid any surprises once you have accessed the funds. Some of the key points to consider are listed below.
- Secured vs unsecured line of credit – choose the one that suits you based on whether you want to offer a collateral or security against the LOC. An unsecured line of credit will be more expensive but will have lesser risk.
- Bank vs non-bank lender – Large banks have cheaper options when it comes to line of credit, but they demand security in most cases. Also, the paperwork involved will be more and you will also need to have a good credit history.
- Fees, payment terms and closure charges – Since each lender will have a different criteria for these, its best to understand and compare a few options before identifying the right lender to approach with your need.
- Alternate options – It is also important for the business owner to understand if a line of credit is in fact the right option for his loan requirement. It is possible that there are other products that could be better suited to the needs of the business.
At Capital Boost, we have tied up with multiple lenders who offer a line of credit to small businesses and understand their products well. We have helped a lot of customers with their business and personal line of credit options and do this with a good understanding of your business and requirement.
If you are looking for a line of credit option to fund your business, speak to one of our LOC lending specialists at 1300 360 530 and we will find the right solution for your need. Alternately, you can fill in the form below and we will have one of our expert lenders get back to you soon.
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