When businesses and individuals need flexible funding options, a line of credit provides access to money they can use as needed instead of a one-time loan. Unlike a traditional loan that gives you a fixed amount all at once, a line of credit lets you borrow money in smaller amounts whenever you need it. However, before applying for this financing option, it's important to understand the various types of line of credit available and how they might benefit your specific situation.

What is a Line of Credit?

A line of credit is a preset borrowing limit that allows you to borrow money whenever you need it, up to a maximum amount. Unlike traditional loans, you only pay interest on the amount you actually borrow, not on the entire credit limit. This revolving credit arrangement lets you borrow, repay, and borrow again without submitting new applications, making it a flexible option for managing cash flow.

A line of credit is different from other loans because you can borrow again after you repay. When you pay back the money you used, that same amount becomes ready for you to borrow again whenever you need it. This creates an ongoing source of funds that can be accessed when necessary, which is particularly helpful for addressing unexpected expenses or taking advantage of sudden opportunities.

How Line of Credit Can Help Businesses?

For businesses of all sizes, different types of line of credit provide critical financial flexibility. Here are several ways they can help:

  • Managing cash flow gaps: When customer payments are delayed but expenses continue, a line of credit helps bridge temporary shortfalls.

  • Seasonal inventory purchases: Retail businesses can stock up on inventory before busy seasons without depleting cash reserves.

  • Emergency funds: Unexpected repairs, equipment failures, or other emergencies can be addressed quickly without disrupting normal operations.

  • Growth opportunities: When sudden expansion opportunities arise, having quick access to funds can be crucial for capitalizing on time-sensitive deals.

  • Project funding: For businesses that work on projects with milestone payments, a line of credit ensures continuous operations between client payments.

Small business owners particularly benefit from lines of credit as they often face unpredictable revenue cycles and need financial tools that adapt to their changing needs.

Types of Line of Credit

Lines of credit come in various forms, with the two main categories being secured and unsecured:

1. Secured Lines of Credit

A secured line of credit is one of the types of line of credit that requires collateral, like a car or property, which the lender can claim if the borrower fails to repay. Because lenders are exposed to less risk, these lines of credit usually have lower interest rates and higher credit limits.

Types of secured lines of credit include:

  • Home Equity Lines of Credit (HELOCs): These use your home as collateral, allowing you to borrow against your home equity. HELOCs generally offer lower interest rates, but put your home at risk if you default.

  • Equipment-Backed Lines: These use business equipment, vehicles, or machinery as collateral.

  • Inventory-Backed Lines: Inventory serves as collateral, making this option suitable for retail or wholesale businesses.

  • Certificate of Deposit (CD) or Savings-Backed Lines: These use your savings account or CD as collateral, typically offering very competitive rates since the risk to the lender is minimal.

  • Invoice-Backed Lines: Also known as invoice financing, these lines of credit use your unpaid customer invoices as collateral.

Advantages of secured lines of credit

  1. Lower interest rates
  2. Higher borrowing limits
  3. Approval may be easier for borrowers with lower credit scores due to collateral
  4. Longer repayment terms

Disadvantages of secured lines of credit

  1. Risk of losing your collateral if you default
  2. Longer application process due to collateral valuation
  3. Potential restrictions on how you use the collateral may limit selling or modifying it until repayment

2. Unsecured Lines of Credit

An unsecured line is a type of line of credit that doesn't require collateral. Instead, approval is based on your credit score, business performance, and financial history. This type of line of credit is more accessible to those who don't have significant assets to pledge, but typically comes with higher interest rates to offset the increased risk to lenders.

Types of unsecured lines of credit include:

  • Business Lines of Credit: Traditional unsecured credit lines offered by banks and online lenders based on your business credit profile.

  • Personal Lines of Credit: Based on your personal credit history rather than business performance.

  • Credit Cards: While not always labeled as such, business credit cards function as a type of unsecured line of credit with revolving terms.

  • Peer-to-Peer Lines: Platforms that connect borrowers directly with investors, often providing quicker access to funds and more flexible terms than traditional lenders.

  • Merchant Cash Advances: Although structured differently because repayments are made as a percentage of future sales rather than fixed installments, they offer upfront funds to businesses

Advantages of unsecured lines of credit

  1. No collateral required
  2. Quicker approval process
  3. No risk of losing specific assets if you default
  4. More flexibility in how you use the funds

Disadvantages of unsecured lines of credit

  1. Higher interest rates
  2. Lower credit limits
  3. Stricter eligibility requirements
  4. Shorter repayment terms

Selecting the right type of line of credit depends on your specific financial situation, available assets, credit history, and funding needs. Secured lines of credit offer better terms but require collateral, while unsecured options provide flexibility without risking specific assets.

Before applying for any of the types of line of credit, start by carefully assessing your business’s cash flow patterns. Next, calculate how much financing you truly need and then determine how quickly you can reasonably repay the amount you borrow. Remember that lines of credit are best used for short-term needs or managing cash flow rather than as long-term financing solutions.

Frequently Asked Questions

1. What are the differences between secured and unsecured lines of credit?

Secured lines require collateral, which usually means lower interest rates and higher credit limits tied to the asset’s value. On the other hand, unsecured lines don’t need collateral but rely on creditworthiness, so they come with higher rates and lower limits. If you default on secured credit, you risk losing the collateral, while defaulting on unsecured credit mainly affects your credit score. Because of this, approval for secured credit depends on the value of the collateral, while unsecured credit approval is based on your credit history.

2. What’s the difference between a line of credit and a letter of credit?

A line of credit lets you borrow money up to a limit and pay interest only on what you use. A letter of credit is a bank guarantee that ensures a seller gets paid if the buyer meets specific conditions, commonly in trade. One provides access to funds; the other guarantees payment in transactions. They serve distinct financial purposes.

3. What is a standby letter of credit?

A standby letter of credit is a bank’s backup guarantee that activates only if a party fails to meet contractual obligations. It works like insurance for payments in leases, contracts, or trade agreements. Banks charge an annual fee based on the risk and amount guaranteed. It is not for regular payments, but serves as a safety net.

4. How do you qualify for a line of credit?

Unsecured lines require good credit scores, steady income, and a clean banking history. Secured lines need valuable collateral with proof of ownership and moderate credit. Both require financial documents and credit checks. Lenders evaluate repayment ability based on credit or collateral.