A common source of credit offered by banks and other financial institutions are called lines of credit (LOC). LOCs are particularly useful for businesses that have funding needs in the short-term. There are three main advantages to using a line of credit as opposed to a bank loan or a traditional credit card.
1. Securing a lower interest rate. Unlike your personal credit card, lines of credit from a banking institution typically provide much more favorable interest rates. Personal credit card rates average 15% interest and can exceed 25% with harsh late penalties. In contrast, a LOC from a bank to a business may range from prime rate to prime plus a percentage over. For reference, prime rates for 2011 were 3.25%.
2. Pay interest only on what you use. Traditional bank loans offer a lump sum deposit into your account and interest is charged on the entire amount, regardless of whether you use it now or save it for a future purchase. With LOCs, interest is charged only on the amount of you use. The remainder, up to the maximum amount, does not generate interest charges until it is used for a purchase. In many cases, revolving LOCs are made available to allow a business owner to draw down and pay back the loan on a continual, as needed basis, ensuring the minimum amount of interest is paid.
3. All purpose use. The third advantage is money secured through an LOC can typically be used for any purpose and purchases are not subject to bank approval. Bank loans can have added stipulations on what types of purchases the money can be used for, especially in the case of loans made for facility upgrades or equipment purchases.
To secure an LOC through a bank (or another lending institution) you will have to provide company financial statements and the last 3 years of your tax returns. The bank’s decision on your loan eligibility and the associated interest rate will be based on these numbers as well as any available collateral. The higher the collateral available, the lower the expected interest rate as the bank’s position is more secure in case of a default. A line of credit in with collateral is referred to as a secured LOC while a LOC with zero collateral is referred to as an unsecured LOC. Typically a secured LOC, all things being equal, garners more favorable interest rates than an unsecured LOC.