Consider the rates when choosing a business line of credit

Cash flow can be one of your most challenging concerns when running a small business. Consider that most small businesses fail in the first five years of operation, according to U.S. Bank. The survey conducted by U.S. Bank reported that poor cash flow management or lack of understanding about cash flow contributed to the failure a stunning 82 percent of the time. If you have or may experience this concern, you may want to evaluate business line of credit rates. 

Some entrepreneurs may think that just increasing revenue is the answer to cash flow issues, but that’s not necessarily the case. Flow is just as important as cash, and understanding when money will come in and go out is crucial to your success. 

Suppose you need to create a supply of widgets for your business to sell in October, but you need to buy the material in February. You have to pay for the materials in February or March, but you won’t see the money coming in from the sales until almost year-end. You are making enough money to support your operation, but the flow is off. That’s an excellent example of cash flow constraints.

What is the best way to address cash flow challenges?

You have options if you need to address a cash flow obstacle. Sometimes the difficulty is temporary. For example, if you can save some of the money you make with those autumn sales, you can use that to pay for the February material restocking needs. That is ultimately a good solution, but it may take a year or two to get there. So what should you do in the meantime?

Consider a business line of credit. A line of credit is similar to a loan but with some built-in advantages. First, lines of credit are flexible. You may not be sure exactly how much you need, but you don’t want to run short and have to apply again in a hurry. On the other hand, you don’t want to pay interest on a loan of $50,000 if you actually need only $25,000. The National Association of Independent Businesses says that a line of credit is “like an insurance policy that never needs to be paid until you need it.” The security of knowing you have access to cash via a line of credit can allow you to resolve short-term constraints and also take advantage of unexpected opportunities.

How is a line of credit different than a business loan? 

Unlike a business loan, a business line of credit allows you to use as much as you need and only make payments on the amount you use. Because of that element, it sometimes makes sense for a business owner to apply for a bit more than they expect to need. There is no disadvantage, and it may come in very handy. If you obtain a $100,000 loan, the interest you pay is based on the entire amount. In contrast, if you have a line of credit, you only pay for what you use. The business line of credit rates may be less than those for a flat loan and are almost always lower than those attached to a business credit card. 

How do I obtain a business line of credit?

You can apply for a business credit line with the financial institution you use for your checking and other business banking needs. However, keep in mind that you might not get the best line of credit rate from that financial institution. Sometimes, a credit union might have a promotion on rates, and you may also want to research the rates available from online banks. 

The business line of credit rate you pay will depend on several factors:

Overall interest rates. As the Federal Reserve Bank Board of Governors increases the federal funds rate (which is the rate that banks charge each other for overnight loans), the effect trickles out to other interest rates. Everything from mortgage rates to credit card interest rates follows the federal funds rate to some degree.

Your business creditworthiness. A lender will offer you a business line of credit rate that reflects their view of how likely you are to manage your payments effectively. If your business is new, part of the calculation will also include your personal credit history. 

Whether your line of credit is secured or unsecured. If you have collateral to offer, you can probably get a lower interest rate. Collateral is something—often property—that the lender can use to recover their money if you don’t pay the loan back as agreed. It’s like mortgaging your house: the bank can sell your home to recoup their loss if you don’t make the payments. 

Fixed or adjustable. As with other loan options, taking an adjustable interest rate might allow you to start with a lower rate. In high-interest rate environments, an adjustable rate may offer relief if rates fall. Most business line of credit rates are adjustable. Although you can probably find a fixed rate, it will be higher to reflect the increased risk.

Should I apply for an SBA-guaranteed line of credit?

One common misconception about SBA loans is that the money comes from the government. In fact, the Small Business Administration (SBA) guarantees loans made to small businesses by participating lenders, including banks and credit unions. These guaranteed loans may make the difference between approval and rejection for some small businesses. However, the downside is that these loans or lines of credit may take longer to approve, and the line of credit rate may not be competitive with a product that doesn’t require the SBA guarantee. Therefore, business owners should research and evaluate their options. 

Is establishing a line of credit a good idea?

A traditional loan might make sense if you have a specific need for a fixed amount and a fixed rate. But remember the report cited earlier, which noted that cash flow constraints play a role in 82 percent of small business failures. You may not be able to forecast accurately when and how much cash you will need until you have been in operation for some time. Therefore, it’s much better to have access to a line of credit you can use as needed. Even if the line of credit rate is a bit higher, you gain peace of mind by knowing that you can respond to issues as they arise. Planning for business uncertainties may make the difference between success and failure.