Lack of capital and cash flow remains a major concern for most small businesses. In fact, it ranked first on the list of top challenges faced by small business owners in Guidant Financial's 2020 Small Business Trends survey. Many small business owners are turning to a business credit line to address their funding needs.
What is a line of credit?
A line of credit is a way for businesses and individuals to borrow the funds they need to make purchases and pay bills or other expenses, such as employee salaries. The line of credit on a business credit card can also be used as a cash advance.
All lines of credit have a limit set by the bank, credit union or other financial entity that provides them. The limit is flexible, and the bank may be willing to increase it, depending on factors like the financial health of your business and whether you make scheduled repayments on time.
A line of credit can be either secured – i.e., backed by collateral such as a building or home – or unsecured. With this type of financing, you only pay back what you borrow, plus interest on the credit you've used. This is the key difference between a credit line and a small business loan. [Read related article: Unsecured vs. Secured Business Loans]
What are the different types of lines of credit?
Lines of credit fall into the following four categories.
1. Business line of credit
You're more likely to be granted a business line of credit if your organization has a positive payment and credit history and can demonstrate that it has the income to repay the money. This type of financing gives you access to funds for any business-related expenses.
Some lenders that extend lines of credit require a business asset, like an office building or piece of machinery, to serve as collateral for the line. Secured business lines of credit typically carry lower interest rates than unsecured lines.
2. Business credit card with a revolving line of credit
A business credit card may be the place to start if your business is new and can't yet meet the requirements for a business line of credit from a bank.
In addition to allowing you to charge purchases up to a certain limit, a business credit card generally gives you the option of taking a cash advance. Some cards have lower cash advance limits than the regular credit line on the card, though.
3. Personal line of credit
This type of financing provides access to funds for personal use. Some people open a personal line of credit to have on hand for emergencies. Others do so for a specific purpose, like buying a home, paying for a wedding or financing a child's education. A personal line of credit can be secured or unsecured.
4. Home equity line of credit (HELOC)
Homeowners who have amassed equity in their property may qualify for this type of financing.
Equity is the difference between the market value of the home and any liens or mortgages currently outstanding on it. For instance, if your home is worth $400,000 and your outstanding mortgage is $250,000, the equity in that home is $150,000.
Homeowners use HELOCs for various purposes, such as remodeling or renovating a home, financing a child's college education, buying a car, or purchasing a second home or other real estate. Some people turn to a HELOC when they need to pay off credit card debt or other personal loans.
How does a revolving line of credit on a business credit card work?
A revolving line of credit on a business credit card "renews" continuously. As you pay down or pay off your outstanding balance, your credit line increases up to the limit set by the bank that issued it.
For example, say you open a business credit card account with a $25,000 line of revolving credit. Days later, you use it to buy $3,000 worth of supplies for your business, leaving $22,000 available. If you paid the bill in full the following month, your line of available business credit on the card would once again be $25,000. If you paid it in monthly increments, your available funds for purchases or cash advances would increase by that amount until they reach $25,000.
Your bank will charge interest on your unpaid balance. According to U.S. News, the average annual percentage rate (APR) on business credit cards ranges from 14.22% to 22.18%.
If you take out a cash advance, you'll pay a higher APR plus a cash advance fee, which may be either a percentage of the funds advanced (usually 2% to 5%) or a flat fee (usually $10 to $15), whichever is more money.
What are the differences between a business credit card and a business line of credit?
A business credit card and a business line of credit may seem similar, but keep in mind these four differences between the two.
1. Funding limits
Available credit on a business credit card usually doesn't exceed $50,000. With a business line of credit, that sum can be as high as $250,000.
2. Cost of cash advances
Card-issuing banks charge a fee and a higher interest rate for cash advances than what you pay when using the card for purchases. These higher rates and fees don't come into play when you opt for a business line of credit.
3. Repayment flexibility
A business credit card offers a flexible repayment schedule, allowing you to choose how much of your balance you repay each month, while a business line of credit has a set end date and a fixed repayment schedule spanning six months to three years.
4. Trade-off between fees and rewards
Most banks have a business credit card rewards program. The trade-off is that most business credit cards have an annual fee, which covers the cost of the perks the bank offers in connection with the program.
By contrast, a business line of credit doesn't come with rewards, but it also doesn't carry annual fees.
When should you use a revolving line of credit on a business credit card?
Tapping into a line of credit on a business credit card is preferable to taking out a small business loan for paying ongoing expenses or making a purchase that will be paid off in just a few months, according to Michael Hammelburger, CEO of Expense Reduction Group.
A business credit card also works well in the case of an emergency that you don't have the cash reserves to cover. For example, if the vehicle you drive for business needs repairs after an accident but you can't wait for the insurance payment to get the work done, a business credit card would be a convenient way to pay for that expense.
Hammelburger said a business credit card is not the right option for refinancing an existing debt, buying real estate or making any other type of large investment. A small business loan or business line of credit is a better bet here, primarily because it usually offers a larger sum of money than would be available on your business credit card.
Brian Cairns, founder of ProStrategix Consulting, agreed, adding that a business credit card should not be your first choice for funding your business because even the best credit cards have high interest rates. Occasionally plunking down such a card for a big-ticket item when finances are tight is OK, but only if you can pay off that item rapidly.
Hammelburger also advised against paying personal expenses with a business credit card. "If you do that, separating business expenses from personal ones at tax time is difficult, and I've seen it become a real nightmare. If you make a mistake, it could be a red flag for an audit."
What other financing options exist for small businesses?
In addition to a business credit line or a business credit card with a revolving credit line, you may be considering a small business loan. Here are some of the ways a business credit card differs from a small business loan.
1. Application process
Qualifying for a business credit card is faster and easier than getting a small business loan application approved. Loan applications are more involved, as banks want assurance that your business will be able to repay them. In general, they look for a good debt-to-income ratio (with minimal existing debt) and a track record of at least two years in business, among other qualifications.
2. Convenience and flexibility
Accessing funds from a small business loan often takes several weeks. You receive the lump sum upfront, whether or not you need the funds in their entirety, and pay interest on the full amount of the loan.
With a business credit card in hand, you can immediately charge purchases or access cash, and you only pay back what you've borrowed (with interest, if applicable).
3. Rewards and incentives
Depending on the issuing bank, you may receive a sign-up bonus or earn airline miles, shopping discounts, dining discounts, or other perks for using your business credit card. You may also earn cash back on purchases you make with the card. Business loans don't come with these incentives.
4. Cost of borrowing money
The interest rates on business credit cards are usually much higher than the interest rates on small business loans or fixed lines of credit from a bank. These rates can increase over time, and interest adds up very quickly if you don't pay your bill on time and in full each month. Also, inadvertently exceeding your credit limit or paying your bill late can incur fees and penalties that put a big financial strain on your business.
Business loans have lower interest rates, but again, you're paying them for the full amount of the loan.