In my July Cash is King post, I briefly mentioned lines of credit as providing one possible solution for a small business facing cash flow problems. With the holidays right around the corner, businesses stocking up on inventory, and potential customers opening up their wallets, I thought it would be helpful to revisit lines of credit and explain how a business can best take advantage of one.
First, let’s define what a line of credit is and how it differs from a term loan or a credit card. Basically, a line of credit is an agreement from your bank to extend money to your business as needed up to the approved limit. If it sounds like a credit card, that’s because it acts very similarly, but has a few important differences:
- Swipe vs. Check: Credit cards are popular because of their convenience. Many businesses, however, need the ability offered by lines of credit to write checks. Landlords, suppliers, or your employees are unlikely to accept credit cards, but they will happily take a check.
- Interest Rates: Just like most financial products, lines of credit vary greatly, but most tend to have lower interest rates than your typical credit card. This is especially true of lines secured by collateral, such as property. When making small purchases on your personal credit card, a high interest rate may not be a concern, but for a small business, charging significant monthly payments, interest can really add up.
Although most can benefit from a line of credit, entrepreneurs should be careful how they use it. Knowing when to apply for a term loan, use a credit card, or tap into a line of credit can save a small business a lot of money and significantly impact available cash. A few simple rules can help decide what product is right for each occasion:
- Major Capital Investments: In most cases, large investments like equipment or renovations are best financed by a term loan. Term loans have the great advantage of spreading payments over several years. Longer terms mean that smaller monthly payments will tie up less cash, giving the business owner more flexibility to pay off day to day expenses.
- Short-Term and Regular Expenses: Like credit cards, lines of credit are revolving. This means that, as long as you haven’t maxed it out, the money is always available. While a term loan provides a one-time cash injection, a line of credit can be used and paid and used again as the business owner needs.
- Safety Net: Some business owners see no need for credit and others are uncomfortable borrowing money. I tend to think that almost any business can benefit from a line of credit, even if it’s just used as a safety net. Business can be unpredictable and having money that can be easy accessed to repair a broken fridge or buy inventory when a good deal comes around can make the difference between a successful business and one that constantly struggles to keep its head above water.
So, how do you apply for a line of credit? As you can imagine, no two lines are the same and no two lenders will ask for the same documents. Some may ask for three years of taxes and a cosigner while others will want to see your bank statements. For this reason, it can be helpful to speak to an Account Manager at your local NYC Business Solutions Center who can determine if a line of credit makes sense for your business and guide you through the application process.
Manuel Dominguez is the Director of the NYC Business Solutions Centers in Brooklyn. If you have a question or comment for Manny, drop him a note below. And, please share this blog entry with your colleagues on Facebook, Twitter, LinkedIn, email, and your favorite social media sites.