Businesses often use revolving lines of credit to manage their working capital needs, smooth out cash flow fluctuations, or fund inventory purchases.
Individuals may also utilize it for personal purposes, such as home improvements, debt consolidation, or covering unexpected expenses.
What is a Revolving Line of Credit?
A revolving line of credit is a credit account that allows the borrower to draw funds up to a specified credit limit.
It offers the flexibility of repeatedly borrowing against the same credit line without having to reapply for a new loan.
The interest is paid only on the balance. As the borrower repays the borrowed amount, the credit becomes available again, allowing the borrower ongoing access to funds.
Example of Revolving Line of Credit Suppose Sam Manufacturers are approved for a $50,000 revolving line of credit but don't immediately use any funds. Later, they receive a large order requiring additional inventory.
They decide to withdraw $10,000 from the line of credit to purchase the inventory. This leaves them with $40,000 still available in their credit pool.
After repaying the $10,000 (including interest charges) as agreed, the entire $50,000 becomes accessible once again.
By promptly repaying their debt, Sam Manufacturers’ revolving credit funds regain their availability for future use.
Is a Revolving Line of Credit Good?
Revolving lines of credit are ideal for businesses that need periodic working capital for expansion or ongoing operational needs.
It is also beneficial for those borrowing against assets to cover expenses or refinance high-interest debt.
What is the Interest Rate on a Revolving Line of Credit?
Typical interest rates on a revolving line of credit can range from 10% to 29%, based on credit history and the lender.
However, the interest rates for business lines of credit range from 5% to more than 20%.
How to Qualify for Revolving Line of Credit?
Lenders consider four main factors when qualifying a business for a revolving line of credit.
These factors are:
-Personal credit score:
Personal credit history is significant in assessing financial management. A score between 660 and 700 makes your business eligible for a revolving line of credit.
If it is higher than 700, you could work with a lender and score a lower interest rate.
- Years in business:
An experienced business with sufficient years of establishment indicates its ability to overcome challenges, making it eligible for larger, more cost-effective revolving credit options.
- Annual revenue:
Lenders typically determine the credit limit for a business based on its generated annual revenue.
Ideally, a business should have a minimum of $120k or higher in annual sales revenue to meet the qualification criteria for a business revolving line of credit.
- Average bank balance:
The amount of funds in the bank account gives lenders insights into the cash flow, business profitability, and ability to handle unforeseen circumstances.
A lender may ask for a balance sheet or an income statement to assess these aspects.
Advantages of Revolving Line of Credit
Some of the benefits of revolving line of credit:
1. Cash flow management:
Businesses can use the credit line to cover expenses during slow periods or bridge gaps between receivables and payables. This ensures smooth operations without interrupting other business activities.
2. Ongoing access:
Unlike traditional loans, a revolving line of credit provides ongoing access to funds.
As the business repays the borrowed amount, the credit becomes available again.
This allows them to borrow repeatedly without reapplying for a new loan.
3. Cost savings:
Businesses only pay interest on the amount borrowed.
This can be more cost-effective compared to a term loan, where interest is charged on the entire loan amount from the beginning.
By repaying the borrowed funds promptly, businesses can reduce interest costs.
4. Emergency preparedness:
A revolving line of credit gives businesses access to funds quickly, allowing them to address urgent needs.
Businesses can use these funds in case of emergencies or unforeseen circumstances.
What is a Good Amount of Revolving Credit to Have?
The amount a business owes contributes to 30% of its credit score. This makes it crucial to avoid excessive reliance on extended credit.
Maintaining a lower credit utilization ratio, ideally below 10%, is highly favorable and signals responsible credit management to lenders.
3 Types of Credit Lines
A line of credit (LOC) is a predetermined borrowing limit available whenever necessary.
The borrower has the flexibility to withdraw funds as required until the limit is reached. In the US, there are three common types of LOCs:
1. Personal lines of credit:
PLOC provides borrowers with a predetermined amount of money they can borrow for a specific duration, known as the draw period.
This allows them to draw the needed funds from the available balance, and interest is only charged on the borrowed amount.
2. Business lines of credit:
A business line of credit allows a business to access a predetermined amount of funds and incurs interest charges solely on the borrowed amount.
3. Home equity line of credit:
HELOC is a revolving credit line secured by the borrower’s home, which allows them to use the funds for significant expenses or consolidate higher-interest debt from other loans, such as credit cards.
They typically offer lower interest rates than other loan types, and the interest paid may be tax deductible.
Disadvantages of Revolving Line of Credit
1. Withdrawal requirements:
Some lenders in the US may impose withdrawal requirements. These requirements mandate that borrowers withdraw a minimum amount of money within a specific timeframe.
This ensures that they generate some profit from the line of credit. The minimum draw amount can vary, but some require a 10% minimum draw.
2. Fees and charges:
Certain lenders may impose inactivity fees if a revolving line of credit remains unused for a specified period, usually one year.
Withdrawal fees also may apply, with charges ranging from 1% to 3% of the withdrawn amount, each time funds are accessed from the account.
3. Lower capital:
Compared to traditional term loans or other financing options, revolving lines of credit generally offer lower funding access.
While some loans can provide borrowing limits of up to $5 million or more, revolving lines of credit typically have a maximum amount of around $300,000.
This is especially true for unsecured business lines of credit.
4. Higher interest rates:
Revolving lines of credit, particularly short-term ones, generally have higher interest rates compared to other financing options.
The quick and flexible access to funds provided by it often comes with higher borrowing costs.
Revolving Line of Credit vs a Line of Credit
Within the domain of lines of credit, there exist two distinct categories: revolving and non-revolving.
A non-revolving line of credit has a predetermined credit limit established, permitting multiple draws.
However, the credit limit signifies the maximum borrowing capacity overall, as opposed to the maximum borrowing amount at any specific instance.
How Can Revolving Credit Help Your Credit Score?
Revolving credit helps in determining the credit utilization rate. This helps measure the percentage of the total available credit.
Credit utilization is key in calculating credit scores, second only to payment history.
By consistently paying down the revolving balance, the credit score will improve and increase the amount of available credit to use.