By Steve Nicastro
As a small-business owner, it's a foregone conclusion that one day you'll be in a financial pickle. Having a solution in place before this happens could mean the difference between panic and peace of mind when you experience a slowdown in business, a sudden lack of inventory, or an unpleasant surprise, such as flooding from broken pipes. One possible solution is a business line of credit.
This type of financing offers flexible access to cash to fund short-term business needs. You'll be granted a credit limit, but you'll pay interest only on the funds you actually use, and the money will be available whenever you need it.
Chris Chen says his financial advisory business tends to be quiet in December: "People are busy doing other things. At the same time, I have expenses like everyone else."
He uses a business line of credit for his Waltham, Massachusetts-based Insight Financial Strategists. "For me, it's helpful to have a line of credit that I can tap into during those slow times that I can then repay during the flusher times," Chen says.
But like any other financial product, there are important factors to consider before applying for a business line of credit. First, ask yourself these five questions:
1. Will you qualify?
Lenders will base your qualification for a business line of credit on your business history (how long you've been in operation), business credit score (or your personal credit score if your business doesn't have one yet), annual revenue, cash flow, and your ability to provide collateral.
Business lines of credit may be secured with business or personal assets, such as real estate or equipment, which act as collateral and can be sold if you default on the line of credit.
If you have a poor credit history or none at all and can't provide collateral, unsecured bad credit business loans are an option. Just keep in mind that this type of financing will likely come with a higher APR, lower credit limit, and less favorable repayment terms, since the lender is taking on more risk. The lender may still require you to sign a personal guarantee, which doesn't secure the loan, but makes you personally responsible for repaying the debt if your business can't.
2. How much money can you get -- and how fast?
Each line of credit has a predetermined credit limit, which is the maximum amount of money you can borrow. Make sure the one you're applying for fits your needs. You don't want to waste your time applying for one that maxes out at $30,000 if you need $40,000.
On the flip side, don't apply for a larger credit limit than you need, as it could tempt you to borrow unnecessary money.
"The issue is forecasting cash flow," Chen says. "The amount of credit you take must be easy to repay in the future. You don't want to take more than needed, but it's easy to do so and you have to be disciplined about that."
You'll also want to consider how quickly you can access the line of credit. Keep in mind that it's often much easier to get approved for a smaller line than a larger one. Lenders typically require less documentation for smaller credit lines than they do for larger ones, for which they may require personal and business tax returns, income statements, and profit and loss statements.
Approval time also depends on the type of financial institution. Online lenders can get you a business line of credit within a week or less, but often at a slightly higher cost than a traditional bank. Traditional banks have longer application and underwriting processes, but tend to cost less.
3. What is the APR?
Business owners should know just how much the business line of credit will cost. This is expressed by the line's annual percentage rate, which includes all interest charges and fees, such as origination fees, annual fees, monthly maintenance fees and transaction fees.
Your APR may range from 6% to 36% or higher, depending on your personal credit score, the length of time you've been in business, and your annual revenue and cash flow, among other factors. Lines of credit generally have lower rates than business credit cards, but may cost more in the beginning and have longer approval processes, says Brett Tushingham, a certified financial planner based in Wilmington, North Carolina.
"Some lenders charge upfront fees -- say $100 to $300 or a percent of the credit line amount -- to establish a line of credit," he says, "and may slap transaction fees on each draw."
Your interest rate can also be fixed or variable, meaning it can increase or decrease based on market rates. If yours is variable, consider asking your lender exactly how much rising rates would affect your future payments.
In December 2015, the Fed raised interest rates by .25%, the first such rate hike since 2006. This meant a higher cost for variable rate debt.
4. Can you afford the monthly payments?
It's a simple, yet important question: Once you've accepted a business line of credit, will you be able to repay the bill that comes each week or month? Be sure that weekly or monthly payment is within your reach, particularly if you are taking out the line of credit because your cash flow is uneven.
"What I always tell my clients is to look at their own customers and how they are paying you," says Michelle Dunn, author of "The Guide to Getting Paid" and other books on credit and collections. "If they are paying on time, or 15 to 30 days late, that's going to affect how you pay back this line of credit. You don't want it to be a struggle."
Figure out your weekly or monthly payment ahead of time. For example, a lender that offers interest-only monthly payments might charge 2% or 3% interest per month on your outstanding balance. In this case, a $10,000 balance would result in monthly interest payments of $100 to $200.
Business lines of credit are either interest-only or come with a maturity date. If there's a maturity date -- say, five or 10 years -- the balance must be repaid by that time or refinanced. If you're paying just the interest on a line of credit and you reach your credit limit, you will have to repay principal in order to borrow again. Check with each lender to see which type is offered and take note of any maturity date.
5. Does the lender report your payment activity?
If lenders report to the credit bureaus Experian, Equifax and Dun & Bradstreet, repaying the line of credit on time will be reflected as good credit for your business, Dunn notes. This can help you get better rates if you plan on borrowing larger amounts of money in the future, and it can help you secure more favorable payment terms with suppliers, she says.
For more tips, check out these five steps on how to build business credit.
Steve Nicastro is a staff writer at NerdWallet, a personal finance website. Email: Steven.N@nerdwallet.com. Twitter: @StevenNicastro.
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