How a line of credit works
Think of a business line of credit as a pool of money the lender agrees to make available. The limit is the most you can owe at once. When you draw from the line, the borrowed amount starts to accrue interest; when you repay it, that room opens up again.
Many lines have two phases. During the draw period, you can borrow and repay freely, often making interest-only or small minimum payments. Some lines then move into a repayment period, when drawing stops and the remaining balance is paid down on a schedule. Other lines simply renew each period if the lender is satisfied with the business’s finances.
Some lenders handle each draw as its own small loan with its own repayment schedule. Ask how repayment works for each draw, because it changes the cash a business needs each month.
What businesses use a line of credit for
Because you pay only for what you use, a line of credit suits needs that come and go:
- Smoothing cash-flow gaps when bills come due before customers pay.
- Buying inventory ahead of a busy season and repaying as it sells.
- Bridging the wait on large receivables.
- Keeping a cushion for unexpected repairs or emergencies.
For a one-time purchase with a clear cost, such as a vehicle or a machine, a term loan or equipment financing is often a closer match, since the payments line up with the life of the asset. For a single operating need, the working capital loans page explains lump-sum options.
Secured and unsecured lines
A secured line is backed by collateral. Common forms include lines secured by accounts receivable, by inventory, or by real estate. With a receivables or inventory line, the amount available may be tied to the value of those assets, called a borrowing base, and the lender may ask for regular reports on them.
An unsecured line has no specific collateral, but that does not mean there is no risk to the owner. Lenders commonly ask owners to sign personal guarantees, and many file a general lien on business assets. Unsecured lines also tend to have lower limits and higher costs than secured ones.
The SBA’s 7(a) program (opens in a new tab) includes CAPLines, which are revolving lines of credit designed for short-term and cyclical working capital needs. Like other 7(a) loans, they are made by lenders and backed by the SBA. The SBA loans page explains how that backing works.
What lenders usually look at
Lenders weigh the same basics they use for other business financing:
- How long the business has been operating, and its revenue history.
- The owner’s personal credit and any business credit history.
- Financial statements and tax returns, especially at banks and credit unions.
- For secured lines, the value and quality of the collateral, such as how old the receivables are.
- Existing debts and how much cash flow is left to cover new payments.
A business that keeps clean books and a separate business bank account is easier to review. The separate finances guide and get loan-ready guide cover the groundwork.
Costs and terms to compare
The rate is only part of what a line costs. Ask each lender to put every charge in writing:
- The interest rate, and whether it is fixed or variable. Many lines are variable, tied to a base rate, so payments can rise.
- Draw fees charged each time you borrow, which can make small, frequent draws expensive.
- Annual or maintenance fees, charged whether or not you use the line.
- Unused-line fees on the portion you do not draw.
- Renewal terms: how often the line is reviewed, and what happens if it is not renewed.
- Covenants, such as financial ratios or reporting duties the business must keep up.
Some states, for example California (opens in a new tab), New York (opens in a new tab) and Utah (opens in a new tab), require certain providers of commercial financing to give standardized disclosures before you sign, which can help with comparison.
Pros
- Pay interest only on what you draw.
- Reusable as you repay, without a new application each time.
- Useful as a standing cushion for uneven cash flow.
Cons
- Variable rates can raise the cost.
- Draw, maintenance or unused-line fees add up.
- The lender can reduce, freeze or decline to renew the line.
- Personal guarantees and liens are common, even on unsecured lines.
Red flags and risks
A line that can shrink
A line of credit is not permanent. Many agreements let the lender lower the limit, freeze new draws or decline to renew, often when the business’s finances weaken, which can be exactly when the money is needed. Reading the renewal and reduction terms before relying on a line can prevent a surprise.
Other warning signs: a product sold as a “line of credit” that is really a short-term loan with fixed weekly payments on each draw, draw fees large enough to make small draws costly, and any request for an upfront fee before the line is offered.
The Federal Reserve’s Small Business Credit Survey (opens in a new tab) tracks how small firms use credit lines and other financing, and the CFPB’s small business lending page (opens in a new tab) covers federal data rules for this market.
Questions to ask a lender
- Is the rate fixed or variable, and what base rate does it follow?
- Are there draw fees, annual fees or unused-line fees?
- How is each draw repaid, and over what period?
- How often is the line reviewed or renewed, and under what conditions can you reduce or freeze it?
- What collateral, liens and personal guarantees are required?
- Do you report the account to business or personal credit bureaus?
Frequently asked questions
What is the difference between a line of credit and a term loan?
A term loan gives you a lump sum repaid on a fixed schedule. A line of credit lets you draw up to a limit as needed, repay and draw again, paying interest only on what you use.
What is the difference between a secured and an unsecured line?
A secured line is backed by collateral such as receivables, inventory or real estate. An unsecured line has no specific collateral but often requires personal guarantees and usually has a lower limit.
Does a business line of credit need collateral?
Not always. Some lines are unsecured, but lenders commonly ask for personal guarantees and may file a general lien on business assets even then.
Can a lender reduce or close my line of credit?
Many agreements allow the lender to lower the limit, freeze draws or decline to renew. The terms are in the credit agreement, so it helps to read them before relying on the line.
What are SBA CAPLines?
CAPLines are a kind of SBA 7(a) loan set up as revolving lines of credit for short-term and cyclical working capital needs. Lenders make them and the SBA backs them.