What is a line of credit?

When you're attempting to fund your small business, you might consider opening a business line of credit. Like a credit card, your bank or credit union may allow you to borrow money up to a preset limit. Unlike other types of loans, you'll only borrow what you need, then pay interest on what you've borrowed.

Is a line of credit right for your business? Let's look at how credit lines work and how they stack up to other business funding alternatives.

How a line of credit works

A line of credit is basically a loan that can be accessed when you need it, allowing you to write checks, make credit card payments, and withdraw cash. The maximum amount you can use depends on your preset borrowing limit, as well as the general type of credit line you open.

Unlike an installment loan, you don't have to take out the total amount in a lump sum. Instead, you can use what you need and repay the loan on a recurring basis.

Secured vs. unsecured lines of credit

To open a secured line of credit, you'll use an asset as collateral to open your loan. A home equity line of credit (HELOC) is the most common type of secured line of credit.

The advantage is that secured lines of credit typically have lower interest rates and a higher credit limit than other loan types. The downside? The lender can seize your assets if you fail to repay the loan according to its terms.

Unsecured credit lines do not require any collateral, which means that they typically have higher interest rates and need a higher credit score to obtain. Unsecured lines of credit can be used for personal or business use, but if you fail to repay the unsecured loan, the lender can hire a debt collector to retrieve the funds.

Revolving credit vs. non-revolving credit

Most business lines of credit will be of a revolving type, which should be distinguished from non-revolving lines of credit. A non-revolving line of credit refers to a maximum amount of money set aside for a specific purpose. Examples of this include personal loans, car loans, and payday loans.

Revolving credit (sometimes called "open-end credit") works very differently. Instead of receiving a loan for a set amount, borrowers can write checks and make payments for any purpose they choose. They are only limited by their preset borrowing limit.

This also means that borrowers can make regular payments to pay down their balance, thus restoring their available credit. This is the "revolving" part of this type of credit line since it means that you will be able to borrow, repay, and then borrow again for the duration of the loan.

If this sounds similar to a credit card, it's because credit cards are technically an example of revolving credit. But most banks and lenders will also allow you to open a business credit line that you can use to fund specific business expenses or to have on hand for emergency use.

Draw period and repayment period

There are two general phases associated with a line of credit. The "draw period" refers to the time in which the borrower can draw money from their available credit line freely. You are permitted to repay your balance during this time, but you may only use your line of credit in this period.

The second phase is the "repayment period." At this time, you are no longer allowed to spend money from your line of credit, and you must repay your outstanding balance. You'll also pay interest on the loan. Your financial institution will establish minimum monthly payments that you must meet to repay the loan.

Types of credit lines

Now that we've covered some of the basics of lines of credit, it might be helpful to look at some real-world examples. There are three main types of lines of credit in use today:

Personal lines of credit

An unsecured personal line of credit functions very much like a credit card or personal loan application. When considering your eligibility, lenders will evaluate things like your:

• Credit score
• Credit history
• Personal income

There are many reasons why you might consider a personal line of credit, such as:

• Emergency expenses (car repair, home repair, unpaid medical bills, etc.)
• Home improvement projects
• Debt consolidation (student loans, credit card debt, etc.)
• Covering bills in the event of financial trouble

Those looking for a personal line of credit should pay careful attention to the fine print. Interest rates can vary between lenders. You may also find yourself faced with a large annual fee.

Business lines of credit

Small business owners may want to consider how business lines of credit could provide much-needed funding for significant projects and unexpected expenses. Business lines of credit allow you to reuse and repay the line of credit as often as you need, so long as you make your minimum monthly payment.

To qualify, lenders will expect to review your financial records — namely your bank account information and business records such as your balance sheet or profit-and-loss statements.

Like personal lines of credit, business lines of credit are unsecured, which means your business assets will not have to be used as collateral. Unfortunately, this can mean a lower credit limit and potentially higher interest rates, as well.

Some business owners may find better rates by using online lenders. But this can also mean you'll face an even lower credit limit, higher interest rates, and hidden fees.

Home equity lines of credit

While the above two examples represent unsecured loans, a home equity line of credit (HELOC) represents a secured line of credit since you're using your house as collateral.

Homeowners commonly take out a loan secured by the home to cover the cost of home improvement projects, though nothing prevents you from using the money for any project you wish. Because you're basically taking out a second mortgage, you'll also have to cover the closing costs for a secured loan.

Unlike an unsecured line of credit, the collateral in your home qualifies you for a higher credit limit and a lower interest rate. But like all secured credit lines, this puts your home in jeopardy should you fail to repay the loan.

For this reason, it's generally unwise for business owners to use their homes as collateral for starting a business. Otherwise, you risk losing your home should your business fail to meet its financial obligations.

How do lines of credit affect your credit score?

One of the most important things to understand about lines of credit is their relationship to your credit score.

What credit score do I need to open a line of credit?

First, what credit scores provide the best interest rates? Personal lines of credit demand a high credit score, though the exact requirements may vary by the financial institution you work with.

According to the Consumer Financial Protection Bureau, you'll likely encounter the following rates:

• Super-prime: Credit scores of 720 and above
• Prime: 660-719
• Near-prime: 620-659
• Prime: 660-719
• Subprime: 580-619
• Deep subprime: 579 and below

A  business line of credit largely mirrors these requirements. However, since you're using other business data,  your rates can fluctuate depending on a larger range of factors.

Does a line of credit affect my credit score?

Opening a line of credit can increase the "credit mix" on your FICO report, which can potentially raise your score as long as you're in good standing with other types of loans.

Like other loans, keeping up with your payments can also boost your credit score. Of course, the reverse is also true: Failing to make your minimum payments can decrease your overall score. If your lender is ever forced to close your personal lines of credit, it can have significant consequences for your credit history.

Is a line of credit right for my business?

Should you open a business line of credit? Before you make your final decision, here are some things to consider:

The benefits of a line of credit

On the one hand, a line of credit generally shouldn't be used for one-time, major expenses, which traditional loans can usually cover. But a line of credit can be used to borrow money for things that banks won't typically underwrite.

A line of credit, therefore, offers the following advantages:

• Greater flexibility than a traditional loan
• Can be used to fund ongoing projects and renovations
• Can be used to purchase additional inventory or supplies
• Helps to consolidate business debts
• Can cover unexpected expenses and emergencies
• Can be used to pay contractors who don't accept credit cards
• Provides overdraft protection for your checking account

A line of credit can be a major advantage for small startups or those who need help in regulating their cash flow.

Limitations to a line of credit

At the same time, there are some disadvantages of using lines of credit in your business:

• High interest rates can impact your profit margin
• Secured loans put your assets in jeopardy
• Some credit unions might charge additional fees
• Can increase your existing debt
• Can negatively impact your business credit scores

This means that while lines of credit can be a valuable asset, they should not be relied upon, particularly if your company is struggling to meet its existing financial obligations.

Alternatives to a line of credit

How do lines of credit stack up against other funding options? Credit cards and personal loans also provide ways to manage debt. Here's how they compare to lines of credit:

Business credit cards

A credit card will function in much the same way as a line of credit. Both options provide revolving or open credit, and users will pay a variable interest rate.

The major difference between a credit card and business lines of credit lies in the duration. A credit card issuer will keep the account open indefinitely, while a line of credit usually has a fixed period of three to fifteen years.

Lines of credit can have a lower APR rate, which can mean that lines of credit can be more affordable in some instances than relying on credit card payments.

Personal loans

Personal loans work very differently than a line of credit. They deliver the funds in a lump sum and require fixed monthly payments as the loan is repaid.

Additionally, while lines of credit only charge interest on the outstanding balance, personal loans charge a fixed interest rate that is spread out across all payments. This might make personal loans a better option for those seeking to address a one-time need.

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Frequently asked questions

Still wondering about how lines of credit work? Here are some answers to common questions.