How Do Lines of Credit Work?

A line of credit is a revolving loan typically used to finance short-term or seasonal expenses. What's the best way to take advantage of it?

A line of credit is a revolving loan typically used to finance short-term or seasonal expenses. It works on the same principle as a credit card. You use a line of credit to borrow cash, and you pay interest on the outstanding monthly balance only. Each time the borrower pays back principal, money is freed up again for future loans.

Credit lines can be open-ended (like a standard credit card account), or they can be due at the end of a specified term. Read Understanding Business Lines of Credit for more information.

Personal vs. Commercial Credit Lines

A line of credit can be a personal loan or a commercial loan. Many small businesses, especially start-ups, rely on personal credit lines to finance their companies. A home equity credit line is a good example of a secured personal credit line. Unsecured credit lines are also available, but their interest rates are usually higher.

Commercial lines of credit are preferable to personal credit lines because they use company assets, rather than personal assets, as collateral. Also, you typically have greater borrowing power with commercial lines of credit, although these are generally harder to obtain.

Both types of loans have set borrowing limits. The amount, however, can vary greatly based on a company's collateral and cash flow needs.

Interest rates on commercial credit lines equal or exceed the prime rate, and are based in part on how risky your venture appears to be. Interest rates are thus usually negotiable, and you should shop around before accepting a line of credit from a particular lender.

Access to Credit Lines

Credit lines are easily accessed by calling your bank and requesting a transfer of funds into your business checking account. Some banks let you do the transfer yourself over the Internet. Banks also offer "sweep" accounts, which automatically draw from your line of credit as needed, to help you manage your cash and keep interest payments down.

For an overview of the topic, read the Step-by-Step Guide to Business Credit.

Get more information on other business funding and loan options for launching your new venture at AllBusiness.com.

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