How a business line of credit works: Types, uses, and risks

Published Friday 10 October 2025

Table of contents

• How does a line of credit work?
• Types of business lines of credit
• Example of a line of credit
• Line of credit vs term loan
• How is a line of credit different from a credit card?
• Common business uses for a line of credit
• Interest rates and costs
• Risks of over-using a line of credit
• How do you get a line of credit?
• Manage your business finances with confidence
• FAQs on business lines of credit

Key takeaways

• Apply for a business line of credit before you need it when your financial position is strong to secure better terms and higher credit limits from lenders.

• Utilize a business line of credit for short-term cash flow needs like seasonal expenses, inventory purchases, and bridging payment gaps rather than covering consistent losses or long-term operational costs.

• Recognize that you only pay interest on the amount you actually withdraw from your credit line, making it more cost-effective than term loans for unpredictable or variable funding needs.

• Avoid overusing your line of credit by watching for warning signs like continuous borrowing up to your full limit, making only minimum payments, or growing debt despite stable revenue.

How does a line of credit work?

A business line of credit functions like a business credit card, providing flexible access to capital when you need it most.

You can use a business line of credit in several ways:

• access funds on demand
• pay interest only on what you use
• repay and reuse funds without reapplying
• make payments as your cash flow allows
• Access funds on demand: Draw money up to your approved credit limit
• Pay interest only on what you use: Unlike term loans, you're not charged interest on unused funds
• Revolving credit: Repay and reuse funds without reapplying
• Flexible repayment: Make payments as your cash flow allows

Types of business lines of credit

Business lines of credit come in two forms: secured and unsecured.

Secured lines of credit

A secured line of credit is backed by collateral, such as inventory, equipment, or real estate. Lenders see this as less risky. You may get a higher credit limit and a lower interest rate.

Unsecured lines of credit

An unsecured line of credit does not require collateral. Lenders look at your business credit history and financial health. Because there is more risk for the lender, unsecured lines of credit usually have lower limits and higher interest rates.

Example of a line of credit

A bank gives you a line of credit with a $50,000 limit. You withdraw $10,000 to buy inventory. You only pay interest on the $10,000. You can still use the remaining $40,000.

If you need $5,000 for new shop fittings, you can withdraw that before paying back the $10,000. Interest is charged only on the amount you borrow.

Line of credit vs term loan

Term loans provide a lump sum with fixed repayments, while lines of credit offer flexible access to funds.

You might choose a term loan for:

• Large purchases: Equipment, real estate, or major expansions
• Predictable costs: Fixed amounts with structured repayment plans
• Lower interest rates: Generally better rates for substantial borrowing

You might choose a line of credit for:

• Cash flow management: Cover gaps between income and expenses
• Unpredictable needs: When you can't forecast exact borrowing requirements
• Short-term expenses: Inventory purchases, equipment repairs, seasonal costs

Financial flexibility: Access funds only when needed

How is a line of credit different from a credit card?

Business credit cards and lines of credit differ in structure, costs, and borrowing capacity.

Business credit cards work differently from lines of credit. They:

• are always unsecured
• have higher costs due to increased lender risk
• offer convenience features like rewards programs and expense tracking

Business lines of credit can be secured or unsecured. They:

• may offer lower interest rates, especially if secured
• provide higher borrowing limits
• can lower your costs if you use collateral

Common business uses for a line of credit

Business lines of credit solve common cash flow challenges across different industries and situations.

You can use a business line of credit for many common business needs, such as:

• Seasonal cash flow: Cover payroll and overhead during slow periods
• Invoice gaps: Bridge funding while waiting for customer payments
• Inventory opportunities: Take advantage of bulk purchase discounts
• Equipment repairs: Handle unexpected maintenance costs
• Growth investments: Fund marketing campaigns or expansion projects

Flexible repayment options can help you manage your line of credit, including:

• No prepayment penalties: Pay off balances early without fees
• Variable payments: Adjust payments based on your cash flow
• Interest-only options: Some lenders offer interest-only payment periods

Interest rates and costs

The interest rate on a business line of credit is often variable, meaning it can change over time, and businesses should be aware of IRS rules that generally limit deductible business interest expense to 30% of adjusted taxable income.

Factors like your credit score, time in business, and whether the line is secured or unsecured will influence your rate. Besides interest, some lenders may charge other fees, such as an annual fee to keep the account open or a draw fee each time you withdraw funds. Review all potential costs before you commit.

Risks of over-using a line of credit

Avoid these common mistakes that can hurt your business's financial health.

There are times when a line of credit may not be the best option, such as:

• Covering consistent losses: Address underlying business problems first
• Long-term payroll funding: Indicates serious cash flow issues requiring restructuring
• Routine operational expenses: Suggests your business model needs adjustment

If you notice any of these warning signs, consider seeking help:

• Continuous borrowing: Using your full credit limit month after month
• Minimum payments only: Unable to pay down the principal balance
• Growing debt: Credit needs increasing despite stable revenue

If a line of credit is not right for your needs, consider these alternatives:

• Term loans: Lower rates for long-term financing needs
• Business restructuring: Address root causes of cash flow problems

Accounts receivable improvements: Faster customer payment collection

How do you get a line of credit?

Apply for a line of credit before you need it to secure better terms and ensure approval when opportunities arise.

To improve your chances of approval, apply when:

• your financial position is strong
• cash flow is healthy and revenue is stable
• lenders see your business in good financial standing
• you can qualify for lower rates and higher limits

Lenders usually ask for these documents:

• Financial statements: Balance sheet and income statements (typically 2-3 years)
• Bank statements: Recent statements showing cash flow patterns
• Tax returns: Business and sometimes personal returns
• Credit history: Business credit score and personal credit for guarantors

Most lenders have these requirements:

• at least one to two years in business
• minimum annual revenue, usually $50,000 to $100,000
• good business and personal credit scores

Manage your business finances with confidence

A business line of credit can be a powerful tool for managing cash flow and seizing opportunities. But it works best when you have a clear view of your overall financial picture. With organized books, you can make smarter borrowing decisions and stay on top of your repayments.

Xero gives you real-time visibility into your finances, so you can run your business with confidence, not your books. From tracking cash flow to preparing financial statements for lenders, Xero simplifies your accounting so you can focus on growth.

Try Xero for free to see how easy it can be.

FAQs on business lines of credit

Here are some common questions and answers small business owners might have about lines of credit.

Is it hard to get a business line of credit?

While it depends on your business's financial health, government programs exist to help; for example, in one fiscal year, the SBA guaranteed over 69,000 loans. Lenders typically look for a solid credit history, consistent revenue, and at least one to two years in business. Having your financial documents organized and ready will make the application process smoother.

How do I get a line of credit for my LLC?

The process is similar for all business structures, including LLCs. You'll apply with a lender and provide documents that show your business's financial standing, such as bank statements and tax returns. Lenders are most interested in your business's ability to repay the credit.

What do I need to apply for a business line of credit?

Most lenders will ask for your business's Employer Identification Number (EIN), financial statements such as a balance sheet and income statement, business and personal tax returns, and recent bank statements. Having this information ready can help speed up your application.