Business Line of Credit: How It Works

A business line of credit gives you flexible access to funds.

How a Line of Credit Actually Works

You are approved for a maximum, say $100,000. You draw $40,000 in March to fund seasonal stock. Interest accrues on $40,000, typically calculated daily against a variable rate. You repay $25,000 in June from collections, so interest then accrues on $15,000. In September you draw another $30,000 for a new contract, bringing the balance to $45,000.

Across that year you may have accessed $70,000 in total while never carrying more than $45,000 at once, so you paid interest on roughly $45,000 rather than $70,000. That is the core advantage over a term loan: you pay for what you use.

Costs beyond interest matter. Many facilities charge an unused line fee, typically 0.25% to 1% a year on the undrawn portion, so a $100,000 facility you never touch still costs you up to $1,000. There is usually an annual or renewal fee, and sometimes a draw fee on each advance.

Most facilities run for 12 months and renew on review. Some are committed, meaning the lender must honour the limit for the term subject to you meeting covenants. Others are uncommitted, meaning the lender can suspend or reduce at any time. Committed facilities are worth paying more for if your business depends on the facility.

When a Line of Credit Beats a Term Loan

The distinction is simple: a line of credit suits a need that recurs or fluctuates; a term loan suits a need that is one-off. Getting this wrong is expensive in both directions.

Use a line of credit for seasonal inventory build, funding gaps while waiting on receivables, bridging a large contract before it pays, covering a slow month, and smoothing irregular expenses such as quarterly tax payments.

Use a term loan for buying a durable asset, funding an acquisition, a fit-out, or anything where the benefit lasts for years and the repayment should be spread over the same period.

The common error is using a line of credit for a long-term need. If you draw a facility to buy a machine and never repay the principal, you have converted cheap revolving credit into expensive permanent debt with annual renewal risk. The lender may notice, too: most agreements include a clean-up requirement, obliging you to reduce the balance to zero for a period each year. Failing that requirement is a covenant breach.

The second error is using a term loan for a temporary gap. You create a fixed monthly obligation for a problem that resolves in weeks, and you keep paying long after the problem has gone.

In practice, healthy businesses often hold both: a term loan for assets at a fixed payment, and a line of credit as a working capital buffer.

How Lenders Assess a Line of Credit

Underwriting a line is different from underwriting a term loan, because the lender is funding a fluctuating need rather than a defined purchase.

Cash flow through your bank account. Lenders look at your deposits, the pattern of receipts, and whether you have regular overdrafts. A business that shows consistent, growing deposits will be offered a larger facility.

Receivables and inventory quality. A facility secured on receivables will be sized against eligible receivables, typically 70 to 85% of invoices under 90 days old, excluding concentration above a set percentage from any single customer.

Existing debt. Total debt service is assessed against cash flow, the same DSCR test used for term lending. A line of credit adds to your obligations even if undrawn, because the lender assumes you may draw it.

Time in business. Most lenders want at least 12 months of trading, and 24 months for the larger facilities. Below 12 months, options narrow to secured cards and smaller fintech facilities.

Personal guarantee. Standard, as with almost all small business credit.

Whether the facility is secured or unsecured drives both price and size. Secured facilities against receivables or property are cheaper and larger. Unsecured facilities are quicker to arrange and smaller.

Managing a Facility Well

Draw deliberately, not habitually. Every draw accrues interest from the day it is made. Draw against a specific use, and repay when that use converts to cash.

Repay aggressively. The value of a facility comes from its revolving nature. A balance that sits unchanged for months means you are paying term-loan interest rates on revolving credit, which is the worst of both.

Watch the clean-up requirement. Most agreements require the balance to fall to zero for a specified period each year, often 30 consecutive days. Plan for it rather than discovering it in the agreement.

Never rely on renewal. Treat the facility as available this year, not permanently. If your business model requires it to exist, you have a structural funding problem to solve with equity or longer-term debt.

Check the covenants. Financial covenants, clean-up requirements, and reporting obligations can all be breached without missing a payment, and a breach can allow the lender to freeze the facility.

A business credit card is a form of unsecured line of credit and is useful for very short gaps, but rates are far higher than a bank facility, so it is expensive beyond a month or two.

Worked Example: A Landscaper Sizing a Facility

A landscaping contractor has $850,000 annual revenue, concentrated March to October. It buys plants and materials in spring, pays crews weekly, and is paid 30 to 60 days after each job.

Working capital requirement by month: November and December are close to zero. January is $60,000 as materials are ordered. February $140,000. March $310,000 as crews ramp up. April peaks at $420,000. May $390,000. June $290,000. July $180,000. August $90,000. September $30,000. October zero.

The peak requirement is $420,000 in April. The average across the year is around $160,000.

Approach 1 — size to the average. A $200,000 facility. This is the mistake. It is adequate for eight months of the year and insufficient for the four months when the business actually needs money. In April, the busiest and most critical month, the facility is maxed and there is nothing left.

Approach 2 — size to the peak. A $450,000 facility gives $30,000 of headroom above the April peak. At 11.5% APR with a 0.35% unused line fee, the cost across the year works out to roughly $24,000 of interest on the drawn balances plus around $900 in unused fees. Total cost roughly $25,000, against a business generating net operating income of about $195,000.

The owner initially resists because the unused fee feels wasteful. The reframe: the facility is insurance against the four months when the business cannot operate without it. A facility sized to the average would mean turning down spring work, which costs far more than the fee.

One additional step matters. The owner negotiates a committed facility for 24 months rather than an uncommitted annual one, paying about 0.5% more in fees. This guarantees the limit is available for two seasons rather than one, removing the risk of a withdrawal at the worst possible moment.

Line of Credit vs Other Facilities

Risks and Points of Caution

• Withdrawal at renewal. Lenders can reduce or pull a facility at annual review. A business built around a facility depends on a decision it does not control.
• Clean-up covenant breach. Most agreements require the balance to reach zero for a period each year. Failing this is a breach even with no missed payments.
• Using it as permanent capital. A facility that never reduces is expensive debt with annual renewal risk. If the need is permanent, use term debt or equity.
• Unused line fees on an oversized facility. A facility far larger than you need costs money for nothing. Size to your genuine peak plus modest headroom.
• Unsecured pricing. Unsecured facilities are materially more expensive. If you have receivables or property to secure against, using them lowers your cost considerably.

Setting Up a Facility Correctly

1. Chart your 12-month working capital requirement to find the true seasonal peak, not the average.
2. Size the facility to the peak plus roughly 10% headroom.
3. Ask whether the facility is committed or uncommitted, and what the renewal criteria are.
4. Request the full fee schedule: interest rate, unused line fee, annual fee, draw fees, and any early-close fee.
5. Confirm the clean-up requirement and the exact period it applies to.
6. Ask what financial covenants attach to the facility and whether you currently meet them.
7. Consider securing against receivables or property to reduce the rate, if the assets are clean and well documented.
8. Apply when your balance sheet and bank statements are at their strongest, which is usually outside your peak season.