How Lines of Credit Work

A line of credit or LOC is a loan offered by the bank that allows the borrower to withdraw and repay funds based on the client’s schedule and needs.  This makes a line of credit ideal for both new businesses and existing businesses that need access to additional working capital.  Understanding exactly how they work, why they are beneficial, and potential downfalls for LOCs will enable you to see if they are right for your business.

How Does a LOC Work?

A line of credit works in a similar to a credit card, giving you the freedom to use it when it best suits you. The borrower will take money as they need it, rather than collect the entirety of the loan upfront. The biggest difference is that a LOC tends to have an interest rate that is usually considerably lower than credit cards and has a much higher limit. In addition, withdraws are typically made via checks rather than digital, credit card transactions.

The major difference between a LOC and other business loans is in how interest is collected. Interest on LOC is only charged on the portion of the loan that is actually used. This means that if the company does not use the entirety of the loan they are saved from paying additional interest.  In addition, this interest is only charged when the funds are in use, so as soon as you repay your line the interest immediately stops.

Different types of LOC

There are two different types of LOC. A Secured LOC is backed by collateral, such as a building or valuable asset. They usually come with a much lower interest rate, since the collateral makes them less of a risk for the lender. An Unsecured Line of Credit is not backed by collateral, making it a bit more difficult to get approved.

Who is a good fit for an LOC?

A line of credit is not perfect for all business. The proper usage is based on what the company does, how much they will need to borrow, and how secure they can be in repaying the loan. New businesses make ideal line of credit borrowers, as an a LOC can create more consistent cash flow to tackle unpredictable costs. Additionally, a business may want to opt for a LOC if the purchase they are looking at is smaller and easier to pay off, as they will only need to pay the portion they actually used.  Existing businesses can benefit immensely from a LOC when they might need intermittent access to working capital, but don’t want to tie up all of their funds as cash reserves.

The best use of an LOC is to fund short-term needs.  For example, purchasing inventory, paying operating expenses, seasonal costs or investments, marketing campaigns, financing the delivery of contracts, are great uses.  All of these have an expected financial need with the company knowing beforehand just how much money they will need and how long they will need it before they can start paying it off.  

Potential Downfalls of an LOC

An LOC is not a magic bullet for financial needs. If an LOC can’t be repaid in the short term, it may be wiser to refinance that debt with a cheaper longer-term loan. This ensures that the company won’t be dinged on their credit score. Additionally, projects with a longer completion date are not a good choice for an LOC. Those projects are a better fit for a fixed long-term loan because they can usually get lower interest rates.

How to apply for an LOC loan

Much like a credit card or business loan application, the borrower will typically need to present their credit score, financial records, and compare different offers. Each lender will have different rates and expectations for their loans. Jumping on the first offer may cause the business to miss out on a better offer, or to miss the fact that their needs would be better suited for a different loan. If you have questions about the process of obtaining a line of credit loan, or would like today’s rate quote, our financial brokers can assist you.