Pros and cons of a business line of credit

According to the Federal Reserve Banks’ 2023 Small Business Credit Survey, 43 percent of small businesses who applied for financing sought out a business line of credit, while only 36 percent opted for a business loan.

A business line of credit operates like a credit card, making it a flexible option for businesses. You can withdraw funds as needed to cover unexpected or higher short-term expenses, fill cash flow voids or keep operations running smoothly. Similar to a credit card, you’ll only pay interest on the amount you use, and you’re free to re-use the funds as you pay down the principal balance. You can also get the business line of credit secured or unsecured, depending on if you want to back the line with collateral or not.

Business lines of credit are helpful for smoothing out cash flow in your business or for making necessary purchases to keep your business running. They also help you establish business credit and a relationship with a lender that you can use when applying for new funding in the future. But business lines of credit have a variety of fees that can add up to a high total borrowing cost if you’re not careful.

Before applying, here are some pros and cons of a business line of credit to keep in mind.

Business line of credit pros

Business lines of credit come with many key advantages that make them worth considering.

Improved cash flow

Past-due invoices and seasonal downturns often lead to cash flow issues in businesses. If you’re experiencing either or are dealing with an unexpected expense, it can be challenging to pay bills, take care of your employees and make investments in your business.

A business line of credit helps improve cash flow by giving you a pool of funds to pull from whenever you face these situations. So you won’t have to pause operations or shut your doors for good.

Accessible

If you were denied a bank loan, it’s likely due to your credit rating, time in business or annual income. However, you could have better luck with a business line of credit, even if you’re a startup or have bad credit, as some lenders have more lenient eligibility requirements.

For example, Fundbox’s line of credit accepts businesses with just three months in business and annual revenue of $30,000, some of the lowest requirements on the market.

Competitive interest rates

Interest rates on business lines of credit tend to be low compared to other types of business loans or business credit cards. You’ll generally qualify for competitive terms on a business line of credit if you meet the lender’s eligibility criteria and have a solid credit rating. But online lenders tend to charge higher rates compared to lines of credit from traditional banks and credit unions.

On average, business lines of credit have APRs ranging from 8 percent to 60 percent or higher. Based on data from the Q3 2024 Small Business Lending Survey, the average rates for new lines of credit were 7.44 percent to 8.57 percent, depending on whether it was a variable- or fixed-rate line of credit at a rural or urban bank. By comparison, the average rates for new term loans ranged from 7.75 percent to 8.50 percent.

Build a relationship with the lender

A business line of credit is an effective way to build a relationship with the lender. You’ll have the opportunity to demonstrate you can responsibly manage credit. Doing so could lead to credit line increases or make it easier to renew the line when the draw period ends. It may also help to get a business checking account with the same lender so they can see your cash flow, and you’ll earn trust.  

The lender may also be more lenient the next time you apply for business funding. Or you may qualify for better terms and lower interest rates since you’re already doing business with the lender.

May help build business credit

If the lender reports account activity to the business credit bureaus, you could build business credit with a business line. As your business credit score improves, you could access more funding opportunities and better financing terms.

Business line of credit cons

Despite their flexibility, business lines of credit also come with their fair share of drawbacks.

Fees

Business lines of credit may come with a number of loan fees to watch out for. These fees may drive up the overall cost of a business line of credit:

• Origination fee: Some lenders charge an origination fee when you take out a business line of credit. Some lenders may charge a flat fee, or you may have to pay a percentage of your total loan cost. This fee could be as low as 0.5 percent but can jump as high as 5 percent or more.
• Monthly maintenance fee: You may be subject to a fee incurred each month the business line of credit is open.
• Annual fee: Like a monthly maintenance fee, an annual fee may also apply each year the line remains open.
• Draw fee: You could pay a draw fee each time you withdraw from your credit line.
• Wire transfer fee: This fee may apply if you initiate a wire transfer to draw funds.
• Payment processing fee: Online payments come with a processing fee with some lenders.
• Late fee: You may be charged a late fee if you remit payment past the due date (unless a grace period applies).
• Early repayment penalty: Some lenders assess a penalty if you repay the lender before the term ends, while others don’t charge a penalty or even provide an early payment discount.

May have short repayment terms

For many business lines of credit, you can only pull funds from a business line of credit during the draw period. Once it ends, the amount you owe is converted to a loan and payable over a set period. The loan term may be brief, depending on the lender, essentially turning your line of credit into a short-term loan. Online lenders often have the shortest repayment periods, anywhere from 6 months to 24 months.

Will need to manage the loan effectively to avoid a cycle of debt

Because you can draw from the line up to your available credit as needed, you can easily get into a cycle of debt if you withdraw multiple times without repaying past loans in a timely manner. You’ll need to manage the debt effectively to stay on top of repayments.

To avoid getting into a cycle of debt, estimate the monthly repayments using a business loan calculator before you make a withdrawal. Then, plug the amount into your business budget and prioritize payments when paying for expenses. Be careful not to make too many withdrawals without a plan for repaying the loans.

How to determine if a business line of credit is right for you

A business line of credit may be the right choice for you if you fall into one or more of these situations:

• You need funding that you can access whenever needed
• You have short-term gaps in your cash flow
• You need a low loan amount
• You can pay back funds quickly
• You can adequately manage the line of credit, including whether loan repayments fit into your current budget

Alternatives to a business line of credit

If a business line of credit isn’t the right fit for your company, there are alternatives to consider.

Term loans

Business term loans are a popular funding option offered by banks and online lenders. You’ll receive the funds in a lump sum and repay the balance in equal monthly installments over time. You can get short-term loans with terms of 24 months or less, or you can choose a long-term loan with loans up to 60 months or longer. The longer the term, the lower your monthly payments will be.

Some lenders have stringent time in business, credit score and annual revenue guidelines that can make it challenging to get approved. Online lenders tend to offer short-term loans with relaxed eligibility requirements, such as accepting a fair or poor credit score. You also may not be eligible for the best rates, especially if you have poor credit or are a startup business.

Invoice factoring

Invoice factoring involves selling your unpaid invoices for cash. Most factoring companies offer up to 90 percent of the invoice value. They also assume responsibility for collecting what’s owed. Once the invoice is paid, you’ll receive the remaining balance minus any applicable fees.

This funding alternative is ideal if you need fast cash, but the fees are usually high. The fees may also go up depending on how long it takes customers to take care of the invoices.

Invoice financing

With invoice financing, you can get an advance of up to 90 percent on your accounts receivable — or unpaid invoices. When you receive payment, you’ll repay the amount advanced and any applicable fees to the financing company. With this option, you take on the responsibility for collecting payments. Like invoice factoring, you’ll have to watch out for high rates and fees.

Merchant cash advances

Merchant cash advances (MCAs) are more easily accessible than business lines of credit and traditional business bank loans. They’re typically one of the easiest bad credit business loan options available. Instead of heavily weighing your credit score, revenue and time in business, the lender evaluates your credit card sales to determine your eligibility for funding.

If approved, you’ll receive a lump sum, typically payable in a year or less, through a percentage of daily credit card sales. Despite its convenience, this funding solution also comes with steep fees based on a factor rate. The factor rate, such as 1.10, gets multiplied by the entire loan amount to determine the loan cost and often converts to high interest rates.

And since these are cash advances and not loans, MCAs are not subject to usury laws, which protect people from being charged excessive interest charges. In some cases, it’s possible to get stuck with triple-digit APRs. So, a merchant cash advance should only be used to meet a short-term funding need that can be paid back quickly.

Crowdfunding

You can steer clear of financing to start or grow your business with crowdfunding. It requires you to raise funds for your business either through donations or in exchange for a percentage of your company’s equity or some other incentive. Crowdfunding is an ideal way to avoid all the red tape of applying for a business line of credit or other forms of business financing. This form of financing doesn’t consider your business revenue or credit score. Plus, you can garner increased exposure for your business.

Still, you’ll likely commit a lot of time to the project and risk your idea being stolen. You’ll also need a strong network to reach your fundraising goals, either through your personal network of friends and family or the crowdfunding platform’s network. If you don’t reach your goal, some platforms like Kickstarter won’t allow you to keep the donations raised.

Business credit cards

Business credit cards are another possible funding source for your company. If you have good credit, they generally come with generous spending limits. And some offer sign-up bonuses and interest-free introductory periods. Plus, you can easily track business spending, access employee cards and take advantage of business-related perks and discounts.

But there are significant downsides. Business credit cards are not covered under the Credit CARD Act of 2009, which comes with a host of consumer protections, including the mandatory disclosure of interest rate increases.

Interest rates may also be high compared to business lines of credit. Business credit cards can see APRs between 18 percent and 35 percent. You’ll also need strong credit to be eligible for the best cards; otherwise, you may have to apply for a secured business credit card.

Bottom line

The best business lines of credit help you build business credit, get established with a lender and offer low interest rates compared to other loans. But lines of credit can come with a long list of fees that add up quickly to a high cost of borrowing. You’ll also need to effectively manage the debt and repay quickly to avoid getting in over your head in debt repayments.

Alternatives such as term loans, merchant cash advances or invoice financing could be more viable depending on your company’s financial status and unique needs.

Frequently asked questions

• When is a business line of credit a good idea?

  A business line of credit is best if you want a flexible solution to cover short-term cash-flow gaps. If you need a large sum of cash or a long period of time to pay off your debt, a term loan would be a better option.

• Is it hard to get a business line of credit?

  It depends on the lender and your creditworthiness. Each lender has a set of eligibility criteria that includes a minimum credit score, time in business and annual revenue threshold. If you meet these guidelines, you could be eligible for funding.

• What credit score do you need for a business line of credit?

  Most lenders set minimum credit score requirements in the low to upper 600 range, though some go as low as 500. Remember, the best terms on business lines of credit are usually reserved for the most creditworthy borrower. So, it’s worth improving your credit score before applying if it’s on the lower end to minimize borrowing costs.