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A business line of credit can be a useful financial tool for companies to manage cash flow, bridge gaps between accounts receivable and payable, and take advantage of new opportunities. However, understanding the factors that determine business line of credit rates can be essential to obtaining the best possible terms.
Average Interest Rates on Business Lines of Credit
As of 2021, the average interest rate on a business line of credit ranges from 8% to 80%. The interest rate can vary based on several factors, including the borrower's creditworthiness, the lender's underwriting criteria, the amount of credit requested, and the term length.
Additionally, market conditions such as the prime rate and the overall economy can also impact business line of credit rates. It's important for businesses to shop around and compare offers from multiple lenders to secure the most favorable interest rate for their needs.
Lines of credit let you borrow money when you need it and draw from the line of credit multiple times
How Does Interest Work on a Business Line of Credit?
Interest on a business line of credit works a bit differently from term loans, however, it’s similar to a credit card. With a line of credit, you’re given a credit limit, which is the maximum amount you can draw from the line. You can draw smaller amounts and make multiple draws, which means you only have to borrow the exact amount you need, and only when you need it, which makes lines of credit highly flexible.
You only pay interest on the outstanding balance of the line of credit rather than the full credit limit.
For example, if you have a $100,000 line of credit, but have only drawn $5,000 from it, you’ll only pay interest on the $5,000 balance.
Depending on your loan agreement, you’ll either make a monthly payment equal to the interest that accrued that month or make one that includes all accrued interest and a portion of the outstanding balance.
You’re free to pay down the balance at any time. If you do, interest will accrue on the new, lower balance.
What Determines Business Line of Credit Interest Rates
Interest rates are complicated and can be impacted by multiple factors, including:
Credit History
Your credit history is one of the top factors in determining the interest rate on a business line of credit. Your lender will likely look at both your company’s credit history and your personal credit history when making a lending decision.
The higher your credit score, the lower the interest rate. Lower scores mean higher rates or even getting denied for a loan. To keep your credit score high, the most important things you can do are make your payments in a timely manner and keep your overall debt low.
Rates Set by the Federal Reserve
The interest rate market is another significant factor in the interest rates you see for every type of business and consumer loan.
The Federal Reserve sets a target interest rate, called the Federal Funds Rate, which it uses to respond to changes in the economy. When inflation is high, the Fed raises rates to slow spending. In a weak economy, it spurs spending by lowering rates.
The Federal Funds Rate is a benchmark rate that influences rates across the economy, so your line of credit’s cost will vary with changes to the Federal Funds rate.
Time in Business
The longer your company has been in business, the lower the interest rates you can expect. A longer operating history indicates that your business is stable and unlikely to fail in the near future. That means less risk for the lender.
Annual Revenue
The higher your company’s annual revenue, the more money it has available to make payments on loans and lines of credit. That means that higher revenues indicate less risk for lenders. Lenders will be more willing to offer lower interest rates and higher loan limits to businesses with greater revenues.
Collateral
If you can offer some form of collateral to secure your line of credit, you’ll both make it easier to qualify for and lower the interest rate. You can use almost any valuable asset as collateral or deposit funds to a CD with your lender.
You only pay interest on the current outstanding balance
How to Calculate Interest on a Business Line of Credit
Calculating the interest on a business line of credit can vary depending on the lender's specific terms and conditions. However, the general formula for calculating interest on a business line of credit is as follows:
Interest = Principal x Interest Rate x Time
Principal: This is the amount of credit extended to the borrower.
Interest Rate: This is the annual interest rate expressed as a percentage.
Time: This is the amount of time the borrower has used the credit, typically measured in months.
To calculate the interest on a monthly basis, divide the annual interest rate by 12 to get the monthly interest rate. Then, multiply the principal by the monthly interest rate and the number of months that the borrower has used the credit.
Example of Interest Rate Calculation
For example, if a business has a $100,000 line of credit with an annual interest rate of 10% and has used $50,000 of the credit for 6 months, the interest calculation would be:
Interest = $50,000 x (10% / 12) x 6
Interest = $2,500
Therefore, the business would owe $2,500 in interest for the 6-month period
Is a Business Line of Credit Right for Your Company?
Whether a business line of credit is right for your company depends on your specific financial situation and business goals. Here are some factors to consider:
Business Needs: If your business requires ongoing access to funds to cover expenses such as inventory, payroll, or equipment, a line of credit may be a good fit.
Credit Score: To qualify for a business line of credit, you'll typically need a good credit score. If your credit score is low, you may need to explore other financing options.
Financial Stability: Lenders will also look at your business's financial stability, including revenue, cash flow, and profitability. If your business is new or experiencing financial difficulties, a line of credit may be harder to obtain.
Interest Rates and Fees: It's important to compare interest rates and fees from different lenders before deciding on a line of credit. Some lenders may offer lower rates but higher fees, so be sure to read the fine print.
Repayment Terms: A line of credit typically requires regular repayments, and if you don't make them on time, your credit score could be negatively impacted.
A business line of credit may be a good fit if your business has ongoing financial needs, a good credit score, financial stability, and can handle regular repayments. However, it's important to consider all financing options and compare rates and fees before making a decision.
Benefits of Using a Business Line of Credit
Here are some of the benefits of using a business line of credit:
Flexibility: Unlike traditional loans, a business line of credit provides a company with the flexibility to borrow only what it needs, when it needs it. This can be useful for businesses that experience seasonal fluctuations in their cash flow or have unpredictable expenses.
Lower interest rates: Business lines of credit often come with lower interest rates than other types of loans, such as credit cards or term loans. This can help a company save money on interest payments over time.
Access to cash: A business line of credit gives a company access to cash when it needs it, without the need to go through a lengthy application process every time it requires additional funds.
Improved cash flow management: By having access to a business line of credit, a company can manage its cash flow more effectively. It can use the credit line to cover short-term expenses, such as payroll or inventory purchases, without having to dip into its cash reserves.
Build credit: A business line of credit can help a company build its credit score over time. By using the credit line responsibly and making timely payments, a company can demonstrate its creditworthiness to lenders, which can help it secure larger loans in the future.
Drawbacks Of Using a Business Line of Credit
While there are many benefits to using a business line of credit, there are also some potential drawbacks to be aware of. Here are some of the most common drawbacks of using a business line of credit:
Variable interest rates: Business lines of credit often come with variable interest rates, which means that the interest rate can change over time based on market conditions. This can make it difficult to predict exactly how much interest a company will have to pay over the life of the loan.
Short repayment terms: Business lines of credit typically have shorter repayment terms than other types of loans. This can make it difficult for companies to manage their cash flow, as they may need to make large payments on a regular basis.
Fees: Business lines of credit may come with fees, such as application fees, annual fees, or withdrawal fees. These fees can add up over time and increase the cost of borrowing.
Risk of overborrowing: Business lines of credit can be easy to access, which can make it tempting for companies to overborrow. If a company borrows more than it can realistically repay, it may find itself in financial trouble down the line.
Collateral requirements: Some business lines of credit may require collateral, such as equipment or property, to secure the loan. This can be risky for companies that don't have sufficient assets to pledge as collateral.
When Does a Business Line of Credit Make Sense?
A business line of credit is a good idea in a few situations. One is when your business needs to make frequent purchases on credit Applying for a term loan for every $5,000 or $15,000 purchase is a lot of effort and money wasted on application fees. If you’re frequently looking for small amounts of financing for projects, a line of credit will be easier.
Lines of credit are also great for companies with irregular cash flow Instead of waiting on customers to pay invoices, you can use your line of credit to smooth out your cash flow and pay the loan back when you get paid.
Business lines of credit work well in many situations where a business credit card makes sense, but tend to offer higher borrowing limits and lower rates.
Interest rates are determined by many factors, including the market and your company’s credit score.
How to Find the Best Interest Rates on a Business Line of Credit
To find the best interest rates on a business line of credit, use these tips:
Make sure you have good credit: Do your best to have a good credit score, both for yourself and your business.
Shop around: Compare offers from multiple lenders. Each company will offer different interest rates and terms. By getting multiple offers you can choose the cheapest one. You might like to review offers of the best business line of credit lenders on our list.
Build a relationship: Some lenders will offer discounts if you already have a relationship with them. For example, if your business bank also offers loans, see if they have a relationship discount.
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