Among an array of credit options available to businesses, Line of Credit stands out as a viable tool that can significantly contribute to the growth and stability of a company. This borrowing facility offers flexibility and convenience to businesses in accessing funds when required.
In this blog, we will explore the benefits of Line of Credit, its types, advantages, limitations, and more.
What is line of credit?
Line of credit is a short-term financing option for businesses. It allows businesses to access funds as required, supporting their short-term financial goals. Business owners can rely on a business line of credit to sustain seamless business operations, irrespective of fluctuating sales, seasonal variations, or intermittent cash flow limitations.
We may think of Line of Credit as a tool for businesses to pursue opportunities quickly, even when they may not have the cash available to invest.
The lender decides the limit that a business can access and allows them to draw funds from within the limit as and when needed. It works like a loan but gives you the flexibility to pay interest only on the amount used.
For example, you have access to a line with a credit limit of up to Rs. 10,000. You borrowed Rs. 2000 today. You are expected to pay interest only on Rs. 2000, not the whole credit limit. This gives businesses the benefit of saving on interest without getting burdened with loan EMIs.
How line of credit works
Similar to a credit card, a line of credit is a type of ongoing or revolving loan that gives business owners easy access to money to address various financial needs for their business. Unlike most business loans that require you to borrow a set amount and pay it back over a fixed period, a business line of credit is more flexible. With this, you can withdraw money whenever you need, and as you repay, that amount becomes available to borrow again.
Usually, business owners pay back the money they’ve taken from the line of credit on a regular basis, like every week or month. However, some lenders might allow you to pay back the full amount without any pre-closure fee.
For a comprehensive understanding of how a business line of credit functions and its significance in businesses, you can delve into our blog post on understanding credit line: Is it a loan? How does it work in a small business?
Types of lines of credit
There are two types of lines of credit: secured and unsecured line of credit; understanding the difference between the two is crucial for businesses.
Secured line of credit
Businesses must designate specific assets as collateral to get a secured line of credit. Collateral is an asset or property that the lender can claim if the borrower fails to repay the loan. These assets must collectively exceed or equal the total available loan amount—a secured line of credit offers lower interest rates and a higher credit limit.
Lenders consider this option safer, leading to more lenient creditworthiness criteria. If payment is late, the lender can seize assets listed in the line of credit documents, such as accounts receivable, machinery, company property, or inventory.
Unsecured line of credit
Unsecured lines of credit don’t require collateral. They are typically granted based on factors such as the borrower’s credit history, credit score, income stability, and business financials. Lenders assess the borrower’s ability to repay the loan based on these criteria, as there is no underlying collateral to serve as security.
The following table lays down their differences:
|Secured line of credit||Unsecured line of credit|
|Backed by collateral||Not backed by collateral|
|Lower rate of interest and higher credit limit||Higher rate of interest and lower credit limit|
|Specific industries where secured line of credit is used include construction & real estate, manufacturing & equipment financing, retail and inventory management, etc.||Specific industries where an unsecured line of credit is used include professional services, tech & innovation, retail & e-commerce, service-based businesses, etc.|
To know more, read our comprehensive guide on Secured Vs Unsecured Line of Credit.
Advantages of line of credit
A line of credit can be a vital financial resource for businesses, offering a multitude of advantages.
Flexibility: One significant benefit is the flexibility line of credit provides in managing day-to-day operations. Businesses can access funds as needed, enabling them to cover immediate expenses, invest in opportunities, manage cash flow fluctuations, or navigate unexpected emergencies without the need for a lengthy loan application process. This flexibility allows for better financial planning and the ability to seize growth opportunities promptly.
Cost-effective solution: A business line of credit typically charges interest only on the amount withdrawn, offering a cost-effective solution compared to traditional term loans where interest accumulates on the entire loan amount.
Revolving nature: The revolving nature of a line of credit allows for continuous access to funds as repayments are made, making it a sustainable and ongoing financial resource for operational needs.
Establishing and improving credit history: Responsible use of a line of credit can aid in establishing a solid credit history for the business, potentially leading to increased credit limits and improved borrowing terms in the future.
To know about the advantages of business line of credit, read our comprehensive guide on top 10 advantages of a business line of credit.
Things to keep in mind while using lines of credit
While a line of credit offers various advantages, it’s judicious utilisation requires a thoughtful approach. Whether navigating day-to-day operations, responding to growth opportunities, or addressing unforeseen challenges, a strategic and informed approach ensures that a line of credit remains a valuable asset rather than a potential financial burden.
1. Potential for overuse: The accessibility of a revolving line of credit might tempt businesses to overextend themselves, leading to increased debt. If not managed judiciously, it can result in financial strain and difficulty in repayment.
2. Variable interest rates: The interest rates on a line of credit can fluctuate based on market conditions. A sudden increase in interest rates could lead to higher borrowing costs, impacting the business’s financial stability and repayment capabilities.
3. Collateral or personal guarantees: Securing a business line of credit often involves providing collateral or personal guarantees, which can pose a risk. In case of default, the collateral might be seized, affecting the company’s assets or the personal assets of the business owner.
4. Credit limitations: The credit limit for a business line of credit might not always be sufficient to cover larger, long-term financing needs. In scenarios where a substantial investment is required, businesses might need to seek alternative financing options.
5. Fees and charges: Some lines of credit come with various fees, such as annual fees, transaction fees, or maintenance fees. These additional costs can add up and affect the overall cost-effectiveness of the credit line.
6. Potential impact on credit score: Maxing out credit lines or late repayments can negatively impact the creditworthiness of the business, potentially affecting future borrowing options or interest rates.
How to use a business credit line
Strategic use of a business credit line involves careful planning and financial foresight. First and foremost, identify the purpose for which the credit line will be utilised. Is it to manage seasonal fluctuations, cover immediate operational expenses, or invest in growth opportunities? Clear objectives help in determining when to tap into the credit line and ensure its effective use.
Once the need is established, borrow only what is necessary. Access the credit line with a well-defined plan in mind, and ensure the funds are used prudently and aligned with the business’s objectives. Maintain meticulous records of expenses and repayments to manage the borrowed amount efficiently. Constant monitoring of interest rates and repayment terms is crucial to minimising costs and paying off the borrowed amount effectively.
Employ the borrowed funds in revenue-generating ventures or investments that will yield returns. By utilising the credit line funds for ventures that bring in revenue, businesses can facilitate the repayment process while optimising the benefits of the credit line.
When to use a business credit line
Understanding when to use a business credit line is as critical as knowing how to use it. A credit line is best suited for short-term financial needs and opportunities that can generate immediate or near-term returns. It serves as a safety net during cash flow shortages, covers urgent expenses, or acts as a bridge between accounts receivable and payable. Additionally, it can be utilised for capitalising on sudden business prospects or managing unforeseen emergencies.
However, it’s essential to avoid using a credit line as a consistent source for operating expenses. Over-reliance on this resource might lead to an accumulation of debt that can strain the financial health of the business.
Also read: Business Credit Line: How & When to Use One
Comparing line of credit to other types of borrowing
Here’s a comparison table outlining line of credit against other types of borrowing options such as letter of credit, credit card, and business loan.
|Aspect||Line of Credit||Letter of Credit||Credit Card||Business Loan|
|Type of financing||Revolving credit line||Financial guarantee||Revolving credit line||Lump sum borrowing|
|Purpose||Short-term, operational flexibility, cash flow management||International trade transactions, payment guarantee||Short-term operational needs, occasional purchases||Long-term investments, large purchases, expansion|
|Access to funds||On-demand within credit limit||Used for specific transactions||Continuous access to a credit limit||Lump sum upfront upon approval|
|Interest charges||Charged only on amount utilised||Typically no interest but fees are charged||Interest on outstanding balance||Interest on entire borrowed amount|
|Security/Collateral||May or may not require collateral||Requires collateral or guarantee||Typically unsecured||May require collateral or personal guarantee|
|Repayment terms||Revolving repayment based on use||Repayment upon completion of transaction||Flexible minimum payments with interest||Fixed monthly payments|
|Flexibility||Highly flexible, ongoing access and repayments||Specific to transaction guarantee||High flexibility in spending||Limited flexibility, fixed terms|
|Credit limit||Fixed credit limit, replenishes upon repayment||Specific to individual transactions||Fixed credit limit, can be increased||Fixed borrowing amount|
|Credit history||Affects credit score based on usage and repayment||Limited impact on credit history||Affects credit score based on usage and repayments||Affects credit score based on payments|
How can line of credit help business?
A line of credit is a valuable asset for businesses, providing essential financial support in various ways. It facilitates efficient cash flow management by offering a flexible source of funds, aiding in covering immediate expenses and managing fluctuating cash needs. Its primary advantage lies in the operational flexibility it provides, enabling businesses to access funds within a predefined credit limit whenever necessary without undergoing lengthy loan approval processes. This accessibility empowers companies to seize growth opportunities, manage short-term operational expenses, and navigate through seasonal fluctuations. Additionally, the responsible use of an LOC can contribute to building a positive credit profile, potentially improving future borrowing terms. Overall, an LOC acts as a financial safety net, offering immediate support for businesses to cover expenses, seize opportunities, and manage their cash flow effectively.
To know more on how a line of credit can help your business, read: 6 Times a Line of Credit Could Help Your Small Business
What is standby line of credit?
Standby lines of credit function as a safety mechanism for businesses, ensuring their ability to fulfil financial obligations in case of insufficient funds. For instance, a company might establish standby credit lines with a lending partner to cover specific payments to clients if they are unable to meet their contractual commitments.
This type of credit can exist in two forms: secured, where collateral supports it, or unsecured. Financial institutions evaluate the company’s financial stability to ascertain the approved credit line’s size and establish a maximum limit. Sometimes, this credit line is revolving, allowing businesses to borrow funds up to the set credit limit, which, once repaid, become available for borrowing again.
The primary difference between a line of credit and a standby line of credit lies in their utilisation. A line of credit is actively used for short-term financial needs and can be drawn upon as needed with flexible repayment terms, while a standby line of credit remains inactive unless a specific event triggers its use as a financial guarantee or safety net.
How does a line of credit affect my credit score?
A line of credit can impact your credit score in several ways. Responsible management, such as maintaining a low balance relative to the credit limit and making timely payments, can positively affect your score by demonstrating sound credit utilisation and a strong payment history.
However, over-utilisation or consistently carrying high balances on your line can negatively impact your credit rating, indicating potential financial stress. Missing payments or defaulting on the line significantly harms your credit score, signalling financial instability.
The impact of business credit scores on SME loan eligibility is significant. Low credit scores can limit your business from obtaining the right credit products in the market.
How do I pay back a line of credit?
To pay off your line of credit, make regular payments at your own pace, but make sure you meet the minimum payment shown on your monthly statement, which includes interest, insurance (if any), and any additional amounts.
Interest accrues every day, so it’s wise to repay quickly. Clear your balance to avoid further charges. Regular payments above the minimum amount will help reduce interest.
Introducing Razorpay Line of Credit
Did you know that businesses can now effortlessly secure the financial support they require without going through extensive paperwork and complex application procedures? Razorpay Line of Credit presents a solution that enables businesses to access a loan amount of up to Rs. 25 lakhs. Moreover, this credit option is offered without the requirement for collateral or additional fees, reducing the overall expenses associated with the loan for businesses.
So what are you waiting for? Apply for Razorpay Line of Credit: The key to unlock your business growth.