The Surprising Truth: Is a Line of Credit Really a Loan?
Are you contemplating obtaining a line of credit to assist in financing your small business or managing unforeseen expenses? A line of credit is a financial resource that offers access to a pre-approved sum of money that can be utilized as needed.
However, it is crucial to comprehend that a line of credit differs from a traditional loan. Although both enable borrowing money, there are several crucial distinctions between the two that can affect their application and the associated expenses.
This guide explains the concept of a line of credit, including how it works, the different types of credit lines available, and if it’s the right financial solution for you.
What is a Line of Credit, and How Does it Work?
A line of credit (LOC) is a revolving loan that allows borrowers to use the funds they require and only pay back what they owe. It’s also known as a “revolving credit line” and functions up to a limit established by the lender.
Borrowers have access to the funds and can use them in various ways. The most common application of personal lines of credit is credit cards, which allow a credit limit to apply to virtually any use. Business LOCs differ by providing much larger credit lines but limiting the application of the LOC to business expenses.
The expenses provided by business lines of credit include:
- Working capital
- Covering overhead costs
- Revenue generating activities
- Seasonal expenses
Lines of credit can be secured or unsecured. Secured LOCs require collateral from the lender, but have better terms to compensate for the increased security of the LOC. Unsecured lines do not require collateral, but sport significantly higher terms.
How Do Lines of Credit Differ From Other Loan Types?
While lines of credit are lending options, they differ from other loans, especially term loans, in several ways. In the remainder of this article, I will cover how LOCs differ and compare them to other loans.
Fixed vs. Variable Interest Rates
The most significant difference between LOCs and other types of loans is that lines of credit don’t require a fixed interest rate on the entire loan amount, just the amount you’ve currently borrowed. LOCs generally have variable interest rates that can change over time to account for various factors.
Additionally, lines of credit involve revolving funds rather than a fixed amount you receive at once. This line allows you to borrow potentially more if you need them and can pay them back while providing better interest rates overall if you don’t use all the funds.
Fixed vs. Variable Use
Business loans are mostly a one-time use. You apply for a loan to cover specific costs applicable to the loan and use the funds to pay those costs.
However, companies can use LOCs as often as required, provided they pay off what they’ve borrowed. This variability in how typically you can access the funds is essential for businesses with cyclical cash flow or who don’t need a full-term amount up front.
Additionally, businesses require an objective to put funds toward before applying for a term loan. With lines of credit, you can apply for funds before you have a specific business need, allowing you to access funds for emergencies or seasonal fluctuations.
Traditional loans have closing fees that range from 2-7%. These fees are standard, but also increase the extra costs of these loan types.
In contrast, lines of credit generally have minimal or no closing fees. Lack of closing fees isn’t always the case, and factoring the costs will depend on your credit score and time in history.
However, most LOCs will sport lower closing fees and associated costs than traditional loans. A significant factor that impacts the related costs of your loan is the use of collateral.
Use of Collateral
One advantage LOCs have over other types of loans is that they don’t require collateral and are a more immediate and flexible source of funds than term loans.
That being said, these advantages are mostly compensated by higher interest rates and fees associated with credit lines. For example, you are more likely to have closing fees or higher closing fees without collateral.
Depending on your goals and how quickly you need the funds, the choice of collateral can ensure you get quicker and more flexible funds with no collateral or better rates with collateral.
Short vs. Long-Term Use
Most term loans, even short-term loans, are applicable for a year or more. Generally, other loan types are better for longer-term use on a single application, such as real estate acquisition or purchasing new inventory.
In contrast, lines of credit are most applicable for short-term needs that handle various conditions. These needs can include the following:
- Covering overhead costs
- Emergency expenses
- Seasonal business
For example, a flower shop that sees most of its business during early February, May, and December each year wouldn’t require a term loan to handle seasonal traffic. If they have a business line of credit, however, they can purchase new inventory and hire seasonal staff to account for small bumps in business expenses at certain times of the year.
When Are Lines of Credit the Best Lending Option?
Lines of credit are the best credit option for businesses that require a reliable cash reserve for various expenses over a short period. They are the most applicable for covering costs in the short term or at a seasonal rate.
Small businesses with less than two years in business and startups can benefit the most from unsecured lines of credit. These LOCs provide immediate funds and are more readily available than other loan types.
Additionally, LOCs are perfect for revenue-generating activities (RGAs) to boost your revenue stream and bring in additional income. Because of their flexible application, you can use LOC funds to invest in assets or pay off existing credit on other loans.
Get Approved for a Line of Credit Today with BitX Funding
Small businesses and startups looking to fund their business have many options available. However, depending on the application of your loan, some options are better than others.
Lines of credit are a variable interest lending option that provides funds with or without collateral. They are best for short-term and flexible goals and perfect for emergencies or investing in RGAs.
If you want a line of credit today to boost your business, contact BitX Funding to get approved within 24hrs.