What a Business Line of Credit Is Actually For

We established a business line of credit in our second year of operation because our accountant recommended it and the opportunity was available. We did not use it for fourteen months. We did not really understand what we were supposed to use it for.

The line of credit was there. It was available. We were not in a crisis that required drawing on it. We thought of it as an emergency fund and were careful not to touch the emergency fund.

That is not what it is for, and understanding the actual purpose of the instrument changed how we used it and whether it helped.

What revolving credit is

A line of credit is a revolving facility. You are approved up to a maximum amount. You draw on it when you need funds and repay when you can. As you repay, the capacity restores. Interest accrues on the outstanding balance, not on the approved amount.

This is different from a term loan, which is a fixed amount disbursed at once and repaid on a schedule. A term loan has a defined purpose, a defined repayment schedule, and a declining balance. A line of credit is flexible on both draw and repayment, within the limits of the facility.

What it is designed for

A line of credit is designed for bridging gaps in cash timing, not for funding operations that the business cannot otherwise sustain.

The canonical use is accounts receivable gap. You deliver work in month one. The client pays on net-60 terms. Your operating costs are due in months one and two. The line of credit bridges the two months between incurring the costs and receiving the payment. When the payment arrives, you repay the draw. The line returns to zero. You have paid interest for two months on the amount drawn, which is the cost of bridging the gap.

A variation is predictable but lumpy expenses. Annual insurance premiums, equipment repairs, or seasonal inventory purchases: expenses that are known in advance and funded by revenue that arrives over time. The line of credit allows you to pay the lump sum immediately and repay over the period when the revenue arrives.

What it is not for

Funding ongoing operations that the business cannot sustain without the draw is not what a line of credit is for. A business that draws on its line each month to cover payroll because revenue is insufficient to cover costs is using the line to subsidize operations. The balance grows over time. The interest compounds. The line eventually reaches its limit. The business has converted a structural problem into a debt problem, and the debt problem is harder to solve.

The signal that a line of credit is being used incorrectly is a balance that does not return to zero between draw periods. A line that bridges a gap returns to zero when the gap closes. A line that funds operations carries a balance indefinitely, because the operations continue regardless. We used ours as an emergency fund for over a year without understanding this. We are telling you so you do not spend fourteen months getting the same thing wrong.

What it costs

The interest rate on a business line of credit depends on the lender and the creditworthiness of the borrower, but ranges from roughly 7% to 25% for bank and credit union lines. Online lenders charge more. SBA lines of credit typically have lower rates but more stringent qualification requirements.

Beyond the interest rate, some lines charge an annual maintenance fee regardless of usage, and some charge a draw fee each time you pull funds. A line that charges a $500 annual fee and a 1% draw fee is more expensive than the interest rate alone suggests. Read the fee schedule before you establish the facility.

The cost of a line of credit used correctly, for short-term gap financing, is modest relative to the alternative of not having one. The cost of a line used incorrectly, as a source of ongoing operating capital, is the compounding interest on a balance that does not go down, plus the opportunity cost of having borrowed at high rate when the problem was inadequate capitalization.

Establishing the line while you are in a position to qualify for it, before you need it, is the right timing. Banks are more willing to extend credit to businesses that do not appear to need it. The line you cannot get when you are in distress is often available when you are not.