Unsecured Lines of Credit: The Ultimate Guide for Small Business Owners
Table of Content
- Key Takeaways
- What is a Business Line of Credit?
- What is an Unsecured Business Line of Credit (LOC)?
- How to Use an Unsecured Business Line of Credit (LOC)
- Unsecured Business Loan vs. Unsecured Line of Credit: What’s the Difference?
- What are the Pros and Cons of Unsecured Lines of Credit?
- How to Apply for an Unsecured Business Line of Credit
- Bottom Line: Is It Right for You?
Business owners will find themselves in need of a cash flow boost from time to time in the form of small business loans. Even the most established companies may seek cash to address unforeseen expenses or fund business initiatives – anything from replacing broken equipment, meeting day-to-day expenses, or scaling up on inventory, to pursuing strategic business growth opportunities like partnerships or acquisitions.
While there is an array of financing options available out there, business owners tend to prefer a business line of credit because it gives you the freedom to access additional capital, as needed, to plan for revenue-generating initiatives down the road.
➥ Business lines of credit is a revolving credit that allows business owners to draw money from a credit line repeatedly as long as they don’t exceed the set credit limit. They can use the money towards variety of business initiatives like additional working capital or to buy inventory, equipment, and office supplies.
➥ Unsecured business lines of credit are lines of credit that doesn’t require borrowers to present collateral to secure the loan.
➥ The advantages of an unsecured business lines of credit include flexible terms, interest charged only on the borrowed amount, helps in building credit, and continuous access to capital.
➥ The downsides for the financing include high probability of misuse, lower borrowing limit, excellent credit requirements, lengthy application process, and higher interest rates and fees.
➥ Unsecured business lines of credit are best for companies that need quick access to financing, but don’t have an established financial or credit history, or have a poor credit background.
What is a Business Line of Credit?
A business line of credit is a flexible type of financing option that allows businesses to withdraw a certain amount of cash and pay it back later.
Once your application is approved, the lenders will open a credit line and set a credit limit, usually between $10,000 and $5 million. Your limit will be based on your business financials and credit profile, and the type of credit line you’re applying for (secured or unsecured).Once approved, you can put the money towards any business expenses and you’ll only have to pay back the money you used, plus the interest.
A business line of credit is a revolving credit. What does this mean? As long as the credit line stays open, you can repeatedly access it as long as you pay off the balance on time.
A line of credit can be a better choice over traditional loans when:
➥ Your business regularly needs access to short-term capital to meet the company’s daily expenses.
➥ You need to bridge temporary cash flow gaps during slower seasons.
➥ You need extra money to invest in growth opportunities like fulfilling large customer orders.
➥ You have a good personal and business credit profile.
What is an Unsecured Business Line of Credit (LOC)?
An unsecured line of credit (LOC) is simply a line of credit that doesn’t require collateral. You won’t have to pledge a business or personal asset like real estate, equipment, or inventory to secure the loan. This arrangement makes it an ideal financing option for businesses that lack physical assets to pledge.
Moreover, since there is no collateral requirement, there’s less risk involved on the borrower’s part. In other words, you won’t have to worry about losing your home, car, or other valuable business assets.
How to Use an Unsecured Business Line of Credit (LOC)
Small business owners lacking enough assets to take out a more comprehensive loan often turn to unsecured lines of credit to obtain additional working capital. When approved, the business can get as much as $250,000 in credit, depending on the lender and their credit background. The company can then put the money towards business initiatives such as:
➥ Recruiting staff
➥ Bridging cash flow gaps during the business offseason
➥ Buying or repairing equipment
➥ Reordering inventory
➥ Creating a nest egg for any unforeseen expenses that may arise
➥ Product expansions
➥ Opening new locations
Unsecured Business Loan vs. Unsecured Line of Credit: What’s the Difference?
Unsecured business loans and lines of credit don’t require any kind of asset to secure the financing. Both options qualify business owners to a predetermined amount of working capital that they can pay off within a specific period at a fixed interest rate.
The difference between the two financing options lies in the repayment structure. With a small business loan, the funds will be given as a lump sum, and you’re obligated to use all the funds you borrowed. You’ll also have to repay the entire loan amount within a specific term.
In business lines of credit, the financing institution will open a credit line where you can draw any amount of cash any time as long as you don’t exceed the set credit limit. You then repay ONLY the amount you took out from your credit line. So, if you borrowed $2,000 from your credit line with a limit of $10,000, you only have to pay back the $2,000 you owe plus interest.
Moreover, small business loans may require borrowers to pledge a personal guarantee. A personal guarantee is a legal premise wherein the business owner pledges to pay for the financing themselves using their personal assets should the business become unable to do so. With an unsecured line of credit, lenders are less likely to require you to sign a personal guarantee agreement.
What are the Pros and Cons of Unsecured Lines of Credit?
An unsecured line of credit is a viable choice if you don’t have collateral to secure financing. But it offers other benefits, too. Here are four advantages of an unsecured line of credit:
1. Continuous access to additional working capital
If the financing company approves your application, you’ll have access to additional working capital whenever you need it. Plus, you won’t have to worry about pledging assets since it’s an unsecured credit line. This condition makes it feasible for companies that are lacking assets but need additional capital to keep their operations running.
As you withdraw cash from your credit line, the amount of available credit decreases and goes back up once you’ve paid your balance off. You can use it again when the need arises. With that, you won’t have to worry about short-term cash flow gaps or missing out on a potentially profitable business opportunity.
2. Interest rates are applicable only on the borrowed amount
One thing that differentiates lines of credit from other business financing options is that you’ll only pay the interest for the amount you’ve withdrawn from your credit line. If your credit limit caps off at $100,000 and you’ve only used $20,000, you’ll only have to pay interest on the$20,000. If you don’t use any of your credit line, you won’t have to pay any interest. You may still have to pay for the maintenance and other associated fees for your credit line.
3. Flexibility of use
With an unsecured line of credit, you’re free to use the funds as you see fit as long as it’s for your business. Whether it’s to address unforeseen business expenses, buying new equipment, making utility payments, paying staff, or renovations, a business line of credit can give you the cash you need when you need it.
4. It helps improve your credit rating
A business line of credit also helps the company in building its credit profile. As long as you make timely payments and don’t exceed your line’s credit limit, you’ll be able to boost your credit score. As your credit score improves, you’ll have higher chances of qualifying for comprehensive financing options with better terms (i.e., lower interest rates, extended repayment period, etc.)should you want to apply for one in the future.
Like other financing options, an unsecured line of credit also comes with its share of downsides. Here are the cons of applying for an unsecured line of credit:
1. You need to have a healthy business credit profile to get a better loan term
An unsecured line of credit puts much of the financing risk on the side of the lenders. To mitigate that risk, lenders may require the applying business to have a healthy credit profile – ideally a credit score of 670 or higher. You can still qualify for the loan if you don’t meet the requirements, but the terms will be less favorable than if you had a stellar credit profile.
2. High chance of misuse
When you have an open credit line – with unlimited access – it can be tempting to use it for just about any business expense. However, this method of spending could easily backfire. It’s worth noting that a business credit line can only be as useful as you make it. Using it irresponsibly could increase your debt-to-income (DTI) ratio and hurt your credit score. If the debt becomes too high, you could have difficulties repaying it, especially if you’re experiencing cash flow issues.
It should only be used as backup financing to address cash flow shortages or when you need additional capital to pursue a potentially profitable business opportunity.
3. Lengthy application process
The application process for lines of credit involves a lot of moving parts. You may be asked to submit the following documents:
➥ At least three years’ worth of the business’ tax returns
➥ Personal and business bank statements
➥ Balance sheets
➥ Profit and loss statements
➥ Articles of incorporation
➥ Business owner and manager’s resume
All these can take time to collect. Plus, after you’ve submitted the documents, the validation takes more time. The banks and other lenders may still have to do their due diligence wherein they review the borrower’s financial records. This step is important because it lets them assess your qualification and gauge how much risk they’re taking on by entering into an agreement with you.
4. Lower borrowing limit
As there’s no collateral requirement for unsecured lines of credit, most of the risk primarily falls on the lender’s side. Lenders will limit your business’ borrowing limit as a way to mitigate their risk. Typically, an unsecured line of credit can have a credit limit of up to $250,000, depending on the lender. Your credit profile will also determine the amount you’ll be eligible to borrow. The better your credit profile is, the better your chances are to qualify for unsecured credit lines with more favorable terms.
5. It can be expensive
You should be aware that before applying for an unsecured line of credit, the interest rate could be higher than a typical business financing option like small business loans. Rates may vary from one lender to the next. In general, the annual rates for credit lines can go up to 20% or more.
Lenders may also charge businesses with additional fees, like maintenance and processing fees. Late payments and exceeding the credit limit also have their corresponding penalties. Be sure to read the fine print of the contract before signing it. This way, you’ll be aware of the fees associated with your unsecured credit line.
How to Apply for an Unsecured Business Line of Credit
A business line of credit can be a valuable tool that will help businesses like yours fund revenue-generating business initiatives. If you’re planning on securing one for your business, we’ve laid out the steps you can follow below:
1. Check your business’ credentials
Your business’ credentials play a crucial role in your application. Since it’s an unsecured loan, the lenders are facing a much greater risk. Banks and other lenders will want some kind of assurance that you’ll be able to make and afford payments. This could mean presenting a good credit profile and business background to the lenders.
When applying, the last thing you want is to receive a rejection letter which can hurt your credit score. It’s vital to assess these factors before moving forward with the application.
a. Credit score
Credit scores are a testament to your ability to make repayments on time. It’s usually the first thing that lenders look at when evaluating applicants. At the very least, you should have a credit score of 670 or higher to improve your odds of qualifying for unsecured LOCs with better terms.
However, this doesn’t mean to say that if you have a credit rating of less than what’s construed as a good credit score, you won’t qualify for a loan. You can still be eligible, but the terms may be less favorable than when you have a good credit score.
You can improve your credit score by making repayments on time, lowering your debt-to-income (DTI) ratio, or limiting your credit applications.
b. Business age
Time in business is another important consideration for lenders. Young companies, such as start-ups, tend to be riskier as they don’t have an established record for cash flow to prove their capability to pay the loan back. That is why traditional lenders typically require businesses to be at least two years old.
Start-ups can still qualify for an unsecured line of credit, though. Online lenders and other FinTech companies may be willing to take on the risk and approve younger businesses after six months of operation. The downside is, they may charge a higher interest rate to mitigate the risk.
c. Business revenue
To determine if you can afford the repayments, the lenders will look at your business monthly or annual revenue. This will give them a better picture of your monthly or yearly cash flow. It will also play a role as the banks decide how much credit they will grant you initially. If they see consistent growth, they might increase your credit limit, which could mean more growth opportunities for the business.
For traditional lenders, the minimum annual revenue would be $250,000. FinTech companies may approve businesses with lower annual revenue. However, it’s worth noting that a higher annual revenue would afford you better financing terms.
2. Compare different types of lenders
Banks, credit unions, and alternative lenders (FinTech) all offer business lines of credit. However, they do not offer the same repayment terms.
Banks typically offer the best terms – low-interest rates, more extended repayment period, and flexible repayment amount. This makes them the best lender to apply for a business LOC from. But getting approved for an unsecured line of credit from banks is easier said than done. To qualify, you need to bring in at least $250,000 in annual revenue and have to be at least two years old. If this works in your favor, you’d have to wait a few weeks to months to learn the lender’s final decision.
Another alternative to banks is credit unions. Credit unions are non-profit financing institutions owned by their members. Like banks, they offer excellent financing terms. However, you need to be a member of the credit union to qualify.
To join a credit union, you must be a part of the institution’s field of membership, meaning you need to have some kind of ties with the other union members. It could be occupation-based, organizations, community-based, and others. If you’re eligible, you pay a membership fee and may be required to use your account often to take advantage of the services the credit union offers.
One downside of credit unions is that they have fewer ATMs compared to banks. This tends to be a hassle for business owners who draw money in increments.
For companies that can’t qualify for an unsecured line of credit from banks or credit unions, online lenders and FinTech companies could be a viable last resort. Most FinTech companies allow business owners to complete an application form online. Some may even let them upload their financial documents so that the application process can be done remotely. Once approved, the lenders can wire you the funds within 24 hours.
The biggest advantage of FinTech companies is that they often accept applicants who don’t have a great credit score, ample time in business, or extensive financial records. This means that even start-ups can qualify for a line of credit.
3. Understand the credit terms and fees
While shopping for the best lender to apply from, ask them what their credit terms are. Do they prefer monthly, weekly, or daily repayments? While monthly repayments have been the norm for years, it’s common to find lenders that require weekly or daily payments these days. Some may prefer the latter as they won’t have to shell out a considerable chunk of money at the end of every month. The payment process can be automated which is convenient for businesses as they won’t have to worry about missed payments again.
Also, take note of how much interest rates the lenders are charging for the credit line. Banks and credit unions usually charge a 10% to 15% APR, while alternative lenders may go as high as 20%.
Lenders may charge hidden fees for your line of credit. Be sure that you know what they are and how much you’re paying for them.
Here are the most common fees lenders may charge for the unsecured business line of credit:
➥ Draw fee. These are the fees that the lender charges every time you withdraw money from your credit line.
➥ Payment processing fee.These refer to the amount you pay to expedite the transfer of funds from your credit line to your business account.
➥ Late payment fees.Lenders will charge a late payment fee if you miss the deadline for repayments.
➥ Prepayment fees. Borrowers may have to pay a prepayment fee if they choose to pay off their loan balance before the designated time.
➥ Termination fees. If the borrowers decide to close their credit line earlier than the agreed time, the lenders may charge an early termination fee.
4. Prepare the documents
Once you have an idea of where your business stands and where you can apply for a line of credit, the next step is to get the needed documents in order.
Here are the primary documents lenders will expect you to submit when you apply:
➥ Personal information (legal name, social security number, identification, and criminal record).
➥ Bank statements (personal and business)
➥ Balance sheets
➥ Financial statements (cash flow sheets, profit and loss, balance sheets, and revenue sheets)
➥ Credit report (personal and business)
➥ Tax returns (personal and business)
➥ Legal documents (partnership agreements, business permit, registration, business tax ID, licenses, or any legal document that binds you to the other owners of the company)
➥ Debt schedule
Other lenders may also require you to submit additional documents like business leases, articles of incorporation, and manager resumés.
Preparing the needed documents beforehand will help expedite the process of your application. So, be sure to ask the lender what documents they usually require, so you’ll have them ready to submit when it’s time to apply.
5. Submit your application
If you think your business is eligible for an unsecured line of credit and you have all your documents ready to go, it’s time to submit your application.
For banks and credit unions, you may have to go to their branch and submit the application form and documents in person. The process may take several hours, and they may require you to submit additional documents. Again, asking for other documents they might need beforehand will help.
If you’re planning to get a line of credit from alternative lenders, most of them now offer online applications which streamline the process. You’ll be asked to complete a form, and you can upload your bank and financial statements to the platform so the lenders can evaluate your cash flow.
Once approved, go over the contract’s fine print before signing. Pay extra attention to the amount of the credit line granted to you, the interest rates, payment schedule, fees, and how long the loan term is to see if they’re in line with what your business needs and can afford.
Bottom Line: Is It Right for You?
An unsecured business line of credit is a valuable tool that can fuel growth and revenue to businesses. They offer flexibility in terms of spending and repayment structure that no other financing option does. With the additional boost in your cash flow, you can address any business expense, be it day-to-day expenses, seasonal cash flow gaps, or profitable business opportunities.
If your company has a strong credit profile, high enough revenue, and has been in operation for two years, then you might be a perfect candidate for an unsecured line of credit. Just pay careful attention to the terms, interest rates, and hidden fees. Shop around and compare offers from different lenders. Lastly, don’t be afraid to ask questions. The more you know, the more informed you’ll be when making decisions.
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