What is a Line of Credit?

When clients ask us if they can get a loan for their business, we always respond with the truism that “you should never ask a bank for money when you really need it; always have it lined up in advance.”  Their second question normally is “what type of loan should I get?” Banks normally grant two types of standard loans to small businesses. One is called an installment loan and the other is called a line of credit.

Installment loans are utilized to purchase equipment, computers, office furniture and similar types of assets.  A specific amount of money is borrowed for a set period of time (usually three to five years) at a predetermined interest rate that usually does not fluctuate (i.e. – a fixed rate loan).  Monthly payments are required that include both principal and interest amounts.  At the end of the loan period, the purchased asset is usually owned “free and clear”.

A business line of credit is not intended to be used to purchase these types of items.  The term “line of credit” is thrown around quite a bit and you should clearly understand what it is and how it should be utilized.  The purpose of a line of credit is to allow for a business to finance short term and/or seasonal cash flow needs, such as the payment of vendors, the funding of a pension plan or the payment of taxes.  Lines of credit allow businesses to function on a routine basis so as not to be hindered by such things as mail delays, unexpected collection issues, claiming of early payment discounts from vendors and other specific cash needs.

Banks normally structure lines of credit with the requirement that at least once a year there should be a “zero” balance owed for at least a thirty day period.  This requirement, along with others, are called debt covenants which must be met or the line of credit can be “called” and any funds disbursed and outstanding become immediately due and payable.  Lines of credit are usually granted annually, have floating interest rates and require both the company as well as its owners to guarantee the repayment of any borrowed amounts upon the expiration of the line’s time period unless the bank is willing to renew.

Our next blog post will discuss how to qualify for a line of credit from your bank.

Russ Wertz – Founder and CEO of Wertz & Company, LLP, a Professional Services Firm located in Orange County, CA that specializes in working with entrepreneurs along their journey to success.