By Meredith Wood
Whether you’re in the early stages of starting a business or you’ve been established for some time now, you’ve likely come to realize the importance of capital to your chances of success.
Obtaining enough startup capital to get off the ground is one thing. Having consistent access to a pool of funds—which you can use to stave off emergencies, take advantage of bulk deals, move on new initiatives, and make other important financial decisions—is crucial tool that never loses value.
That’s where revolving lines of credit come into play. Revolving lines of credit can take several different forms, but as an entrepreneur and business owner you should work to obtain at least one type to keep in your back pocket. Doing so will make you more flexible and help keep your business’ cash flow steady no matter what comes your way.
Let’s explore revolving lines of credit, including what they are, how they work, and how they can work for you.
What is a revolving line of credit?
Revolving credit is a type of funding where the borrower is given access to a certain amount of credit that they can draw on as needed. You repay each draw (plus interest) on its own schedule and redraw from that pool on a rolling basis.
Unlike term loans, for example, you replenish your revolving credit by repaying it, and can continue to draw from it ad infinitum. You won’t need to reapply or reopen your line after paying off your draw as you do with loans.
If this sounds a lot like a credit card, that makes sense—because a credit card is a form of revolving credit. The other main form (for business owners) is called a business line of credit, which doesn’t offer the perks and rewards of a credit card but typically has a much higher credit limit, and provides access to cash that can be used for virtually any purpose.
What about a non-revolving line of credit?
There is a such thing as a non-revolving (or traditional) line of credit, and it has one fundamental difference from a revolving line: The cash available does not replenish after you pay off your draw.
Why would you prefer a non-revolving line? Generally speaking, interest rates are lower for non-revolving lines than for revolving ones, and the credit limit is higher.
That said, one of the perks of both kinds of lines of credit is that you only pay interest on what you’ve drawn. If you are approved for a $50,000 line of credit, you won’t pay anything for it until you make your first withdrawal—and once you pay it off, you stop paying interest.
The main types of revolving credit
As mentioned above, there are two main types of revolving credit for entrepreneurs: business lines of credit and business credit cards.
What you need to know: Business line of credit
A line of credit combines what’s nice about business term loans (with credit amounts that can reach $1 million—though many products max out at around $300,000) with the flexibility of a credit card.
Repayment term lengths, interest rates, and how fast you’ll be approved will depend on your financial situation, and whether you apply through a traditional lender like a bank or an online lender.
There are some disadvantages to note with a line of credit: Depending on the lender, you LOC may come with draw minimums, draw fees, and inactivity fees. Plus, term loans have much higher lending limits.
A line of credit can be short term or long term, with higher interest rates (from online lenders, who don’t have nearly as stringent an underwriting process) or lower rates (from banks or via the Small Business Administration’s line of credit program). They can also be secured by collateral or unsecured.
What you need to know: Business credit card
If you have a personal credit card, you understand the basics of a business credit card—the only difference is that you should exclusively use the latter on business-related purchases, such as office supplies, inventory, or business travel.
A business credit card will have a much lower spending limit than a line of credit, but a few notable perks elevate the use of credit cards.
For one, credit cards rack up reward points and perks, such as insurance, that you can use to reinvest in your business at no additional cost to you.
Secondly, many business credit cards come with an introductory APR of 0% for a certain time period—which means you essentially have access to an interest-free loan over the life of the offer.
Finally, using a business credit card to exclusively cover your everyday business expenses will help keep your personal expenses separate, which will make tax season much easier to handle. It also maintains the “corporate veil” that forms when you create an LLC, protecting your personal assets in the case of a lawsuit.
Why you need a revolving line of credit
Now that we understand just what a revolving line of credit is and what forms it can take, you might be wondering what makes this source of funding so important that you “need” one. Consider these advantages:
- Flexibility: Between a business line of credit and a credit card, you’ll be able to apply your credit toward paying nearly any business expense. From covering payroll after a slow month to financing a renovation to your brick-and-mortar location, your revolving credit should be able to do it all.
- Emergency funding: The worst time to ask for a loan is when your business is in trouble or when you need it right away. Applying for a loan that funds immediately will almost always result in a higher interest rate than what you’d typically like; applying for a loan when your revenue is down is bound to result in the same, if not rejection. Having your LOC on hand and ready to go when you need it is immensely helpful.
- Evens out cash flow: One of the biggest hurdles that small business owners face is cash flow—it’s often cited as the number one reason why small businesses fail. Whether you’re currently in a low season lull or waiting for a client to pay an invoice, your line of credit can help plug the gaps in your cash flow, rather than forcing you to default on your own debts or miss a payroll cycle.
- Repeated use: As mentioned above, revolving LOCs can be used indefinitely, assuming you repay your draws on time and consistently. Once you qualify for your line, you have almost guaranteed yourself a safety net that lasts as long as the business does.
- No conflict with term loans: If you decide that eventually you need to take out a term loan to pay for a large, long-term expense, you won’t be disqualified simply for having a revolving line of credit. In fact, responsible use of your revolving credit can help build up your credit score and make you a more attractive candidate. The only thing to worry about is maxing out your line of credit and then applying for a loan—a poor credit utilization ratio is a red flag to lenders.
No source of small business funding is perfect. Revolving lines of credit are still forms of debt financing, which means you’re taking a risk in order to gain access to capital that can sustain or supercharge your business.
That being said, revolving lines of credit function as flexible, easy, and relatively low-cost (particularly when unused, of course) financing options—which makes them a valuable commodity for entrepreneurs, who need as much help as they can to succeed in an increasingly competitive world.
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more. Meredith is also the Senior Financial and B2B Correspondent for AlleyWire.