How Interest on a Business Line of Credit Works
Unlike a traditional business term loan, where you receive a lump sum and pay interest on the entire amount, a business line of credit operates on a draw-and-repay basis. You only accrue interest on the funds you actively use.
For example, imagine your business is approved for a $75,000 line of credit.
- You Draw Funds: You need $15,000 to purchase new inventory, so you draw that amount.
- Interest Accrues: Interest begins to calculate only on the $15,000 you borrowed. The remaining $60,000 in your credit line is untouched and does not accrue interest.
- Repayment and Replenishment: As you repay the principal and interest on the $15,000, your available credit is replenished. This revolving credit feature allows you to borrow and repay funds as needed, providing ongoing financial flexibility.
Some lenders may charge an annual maintenance fee or a fee for inactivity, which is separate from the interest rate.
Fixed vs. Variable Rates: Which Is Right for Your Business?
Business lines of credit come with either fixed or variable interest rates, each offering different advantages.
- Fixed Interest Rate: A fixed rate remains unchanged for the duration of the draw term. This provides predictable monthly payments, making it easier to budget and manage your cash flow. Fixed rates are often ideal for businesses that prioritize financial certainty.
- Variable Interest Rate: A variable rate fluctuates over time because it is tied to a benchmark financial index, such as the Wall Street Journal Prime Rate. While a variable rate may start lower than a fixed rate, it can increase or decrease, causing your payment amount to change. This option can be beneficial if you expect benchmark rates to fall but carries the risk of higher payments if rates rise.
What Key Factors Determine Your Interest Rate?
Lenders evaluate several factors to assess risk and determine the interest rate they offer. Strengthening these areas can help you qualify for more favorable terms.
- Business and Personal Credit: Lenders review both your business credit score and your personal FICO® Score. A strong history of on-time payments and responsible debt management signals lower risk.
- Business Financials: Consistent revenue, profitability, and positive cash flow demonstrate your ability to handle repayments. Most lenders will require bank statements and financial statements for review.
- Time in Business: Businesses with an established track record (typically two years or more) are often seen as less risky than startups and may qualify for lower rates.
- Collateral: Offering assets as collateral secures the line of credit, reducing the lender’s risk. Secured lines of credit generally have lower interest rates than unsecured ones.
- Industry: Lenders may consider the risk level of your industry. Businesses in more stable sectors may receive better offers than those in volatile industries like construction or restaurants.
How to Qualify for a Lower Interest Rate
To secure the most competitive rate, take steps to present your business as a low-risk borrower.
- Monitor and Improve Your Credit: Regularly check your business and personal credit reports for accuracy and work on improving your scores by paying bills on time and keeping debt levels low.
- Strengthen Financial Records: Maintain clean, organized, and up-to-date financial statements. This shows lenders you are a responsible and well-managed business.
- Shop and Compare Lenders: Obtain quotes from different types of lenders, including traditional banks, credit unions, and reputable online platforms. Compare not just the interest rate but also any associated fees, such as origination, draw, or annual fees.
- Prepare a Strong Application: A well-prepared application with a clear business plan and detailed financial projections can significantly improve your chances of getting approved with favorable terms.
For more information on preparing for a loan, visit the U.S. Small Business Administration’s guide on how to get a loan.
