Overview
A small business line of credit gives a company flexible access to cash without committing to a single lump-sum loan. Think of it like a business credit card with potentially lower interest and larger limits: you draw funds when you need them, pay interest on what you use, and typically repay to restore available credit.
In my 15 years advising small businesses and arranging working-capital facilities for over 500 firms, I’ve seen lines of credit prevent missed payrolls, enable opportunistic inventory buys, and smooth seasonal revenue swings. They are not a substitute for long-term financing when you need capital for growth projects; instead, they are best used for working capital, short-term gaps, and managing timing mismatches between payables and receivables.
(For official guidance on financing options for small businesses, see the U.S. Small Business Administration: https://www.sba.gov.)
Types of Lines of Credit
- Revolving unsecured line: No collateral required; approval depends on credit, revenue, and cash flow. Rates are typically higher to offset lender risk.
- Revolving secured line: Backed by business assets (inventory, receivables, or equipment) or real estate. Secured lines often carry lower interest and higher limits; lenders may perfect security via a UCC-1 filing.
- Asset-based lines: Underwriting focuses on eligible collateral (e.g., certain percentage of AR or inventory value) rather than purely cash flow or FICO score.
- SBA-backed lines and programs: The SBA sometimes indirectly supports short-term financing; lenders may offer SBA 7(a) or other products for specific needs (see guidance on SBA loan applications for small businesses: https://finhelp.io/glossary/sba-7a-loan-application-common-mistakes-small-businesses-make/).
How Underwriting Works
Lenders evaluate several factors when approving a line of credit:
- Business credit score and personal credit of owners (for small or micro-businesses).
- Cash flow metrics and historical bank statements—most lenders look for consistent deposits and predictable cycles.
- Annual revenue and profitability.
- Collateral quality and liens.
- Management experience and a simple business plan or projections for newer businesses.
Underwriting often includes a review of recent bank statements (90–180 days), two to three years of tax returns, and accounts receivable aging schedules if the line is asset-based. Expect requests for personal guarantees from owners, especially for small firms or new businesses.
Common Fees and Typical Ranges
Fee structures vary by lender. Typical fees you may encounter:
- Interest rate: Variable (prime + margin) or fixed for a period. Small-business lines often range widely—roughly mid-single digits for strong, secured deals to high teens or more for unsecured, high-risk facilities. Always ask whether the quoted rate is APR, periodic rate, or a simple margin over an index.
- Draw or funnel fees: $10–$50 per draw is common for some lenders.
- Annual or facility fee: $50–$500 to keep the line open.
- Unused or non-usage fee: Charged when the line sits idle; lenders may charge up to a few percent of the unused portion annually for some commercial facilities.
- Renewal fee or administrative fee at renewal: Often a flat fee or small percentage.
- Late payment and returned payment fees: Standard fee schedules—know exact penalties.
Fees and rate ranges change with market conditions and creditworthiness. For consumer-facing explanations of credit costs, see Consumer Financial Protection Bureau resources (https://www.consumerfinance.gov).
Loan Covenants: What to Expect and Why They Matter
Covenants are contractual promises meant to protect the lender by monitoring the borrower’s financial health. They can be affirmative (you must do X) or negative (you must not do Y). Common covenant categories:
- Financial covenants: Minimum current ratio, minimum net worth, maximum debt-to-equity, minimum EBITDA or interest coverage ratio. Example: maintain a current ratio >1.2 or ensure debt service coverage ratio (DSCR) exceeds 1.25.
- Reporting covenants: Provide monthly or quarterly financial statements, bank reconciliations, and accounts receivable aging reports.
- Operational covenants: Restrictions on capital expenditures above a threshold, limits on new debt, or prohibitions on liens without lender consent.
- Trigger events and remedies: Defaults for missed covenants may allow the lender to freeze the line, demand immediate repayment, increase pricing, or require additional collateral.
In practice, covenants are negotiation points. A common mistake I see: business owners accept overly strict reporting frequency (weekly or daily) that diverts staff time. Negotiate reasonable thresholds, incremental cure periods, and definitions (e.g., what counts as “available cash”).
Practical Uses and Examples
- Seasonal inventory: Retailers draw against a line to buy inventory before peak season and repay as sales convert to cash.
- Payroll smoothing: Service businesses use lines to cover payroll during slow periods.
- Repair and replacement: Cover unexpected equipment repair without disrupting capital plans.
- Supplier terms: Take advantage of early-pay discounts by drawing short-term funds.
Real example from my practice: A coffee shop obtained a $50,000 line secured by business assets. They drew 40% for summer equipment repairs and repaid as seasonal sales increased, avoiding a long-term loan.
Risks and Common Mistakes
- Overreliance: Treating a line as permanent income can mask underlying profitability problems.
- Ignoring covenants: Missing reporting deadlines or failing a ratio can lead to sudden line freezes.
- Personal guarantees and collateral: Owners often underestimate the personal risk—default can lead to collection on personal assets.
- High utilization: Using a large percentage of your limit can signal risk to lenders and harm personal/business credit scores.
How to Negotiate Better Terms
- Prepare clean, accurate financials: Simplify lender diligence and reduce perceived risk.
- Offer targeted collateral: If you can pledge inventory or AR that’s already well-documented, expect lower pricing.
- Ask for covenant step-downs or seasonal liquidity adjustments if your business is cyclical.
- Negotiate cap on fees: Try to limit unused fees or draw fees, and seek an explicit fee schedule in the credit agreement.
How Lines of Credit Affect Credit
- Business credit: Lenders may report utilization to business credit bureaus—consistent, on-time use and repayment can build business credit.
- Personal credit: Many small-business lines require personal guarantees; delinquencies may show on owners’ personal credit reports and affect FICO scores.
Application Checklist
- 90–180 days of business bank statements
- Two years of business tax returns (if available)
- Personal tax returns for owners (typically 20%+ ownership)
- Accounts receivable aging and inventory lists for collateral
- Business plan or short cash-flow projection
- Articles of organization, EIN, and operating agreement
When to Choose a Line vs. a Term Loan
- Choose a line when your need is short-term, intermittent, or seasonal and you want flexibility.
- Choose a term loan for fixed, one-time investments (equipment, real estate, one-time expansion) where predictability and longer amortization lower monthly payments.
(For guidance on refinancing commercial debt and when that may make sense, see our article on refinancing commercial loans: https://finhelp.io/glossary/refinancing-commercial-loans-key-considerations-for-businesses/.)
Short FAQ
Q: Will a lender always renew my line?
A: No. Renewal is usually at the lender’s discretion and can depend on current performance, collateral values, and covenant compliance.
Q: Can I convert a line to a term loan?
A: Some lenders offer conversion features; converting can lock in a fixed rate and structured repayment but may include fees or different pricing.
Q: Can startups get lines of credit?
A: Early-stage businesses often need to use secured or personal-guarantee-backed lines, or alternative lenders that underwrite on velocity and future sales.
Final Notes and Professional Disclaimer
Lines of credit are powerful when matched to the right need and managed with discipline. In my experience, the healthiest borrowers use lines as a bridge between predictable inflows and outflows, not as a permanent substitute for profitability. Always read the credit agreement carefully, ask for exact fee schedules, and clarify covenant definitions and cure periods.
This content is educational and does not replace personalized legal, tax, or financial advice. Consult a certified financial advisor or lender for advice tailored to your business.
Sources and Further Reading
- U.S. Small Business Administration (SBA): https://www.sba.gov
- Consumer Financial Protection Bureau (CFPB): https://www.consumerfinance.gov
- FinHelp glossary: SBA 7(a) loan application mistakes — https://finhelp.io/glossary/sba-7a-loan-application-common-mistakes-small-businesses-make/
- FinHelp glossary: Refinancing commercial loans — https://finhelp.io/glossary/refinancing-commercial-loans-key-considerations-for-businesses/
- FinHelp glossary: How loan-to-value affects interest rates on secured loans — https://finhelp.io/glossary/how-loan-to-value-affects-interest-rates-on-secured-loans/
