What is a Line of Credit Agreement?
A line of credit agreement allows consumers and businesses to borrow money up to a certain limit from a lender. Rather than make a single lump sage loan for the entire amount, the line of credit agreement provides the consumer or business with a credit line from which it can draw from at any time, but does not require the borrower to draw the full amount. Similar to a credit card agreement, the lender permits the consumer or business to draw down from the line of credit without having to approve each loan. Interest is charged only on the amount actually drawn by the borrower. Among other things, the line of credit agreement will provide the consumer or business with the terms of repayment of any amounts drawn down and the interest rate owed on the amounts , generally a fixed or variable rate.
Lines of credit are perhaps more commonly thought of in the context of consumer transactions, such as a car loan or a home equity line of credit. Business lines of credit agreements, however, also provide businesses and non-profits with access to readily available capital to help fund on-going operations or specific projects. Lines of credit are generally unsecured, meaning the lender does not require the borrower to pledge any collateral in the form of property or equipment. A business or non-profit may choose to secure the line of credit with collateral while the line of credit is outstanding to help lower their interest rates or improve their borrowing terms.
Main Elements of a Simple Line of Credit Agreement
A line of credit agreement with a bank or other lending institution is very similar to a credit card in nature. These arrangements allow a business to borrow funds as needed, up to a certain limit, and repay them over time. The main difference, in many cases, is that a line of credit can be secured with real or personal property as collateral for the loan. This adds an additional layer of risk avoidance for the lender if the loan is not repaid according to the terms of the contract and therefore minimizes the potential for default in many cases.
Here are the basic components of a line of credit agreement:
- Credit limit – This is a set amount that the borrower must not exceed, without incurring additional fees, late charges and interest on the balance in excess of this amount. Credit limits are generally based on a company’s income and credit rating.
- Interest rates – These may vary from month to month or they may be set for the term of the loan, depending on the arrangement between the borrower and lender. Interest rates are influenced by a number of things, including the prime rate, which is partly influenced by the economy. If the economy is doing well, the prime rate will rise, resulting in higher rates for line of credit agreements.
- Repayment terms – A line of credit is generally structured as a revolving credit account, which means that once the borrower has repaid a portion of the balance, that amount is available to be borrowed again. This is different from installment or fully amortized loans, which are paid back over a set period of time in equal installments.
- Consequences of default – Even though lines of credit have some similarities to credit cards, these arrangements can be much more complex than credit card issuers and holders realize. In the case of a company benched by the state to be too big to fail (and sometimes even when it’s not), a default on a line of credit agreement can lead to dire consequences for financial institutions. This has resulted in a number of laws being passed that govern the way each party must act in order to avoid mistakes that can have devastating effects on the stability of the greater economy.
These rules generally dictate when a lender can and cannot impose fees and charges on the borrower for exceeding the credit limit and what actions may result in the lender being unable to collect the total value of the loan, because it did not follow certain protocols when extending the line of credit agreement.
Advantages of a Simple Line of Credit Agreement
The advantages of a line of credit are flexibility, the ability to only pay interest on the amount used, and the ability to use the line to cover emergencies, cash flow shortages, or for other purposes without having to disturb a loan made for another purpose. Lines of credit are generally more flexible than loans because money can be borrowed, repaid and borrowed again, so long as repayment is made within a certain time frame, or money is drawn down on and repaid on a set schedule. Lines of credit also give borrowers the option of only paying interest on the funds that are accessed, and are a convenient way of financing a number of purposes without having to apply for a series of separate loans.
Typical Terms and Conditions
A simple line of credit agreement will contain many of the terms that are found in a typical commercial loan. These terms should be read carefully before signing – given that the line of credit will be used to finance the business, you need to understand how the lender can enforce its security and what the lender can do if you default. This section is a guide to some of the terms that are commonly found in a simple commercial line of credit agreement, as well as common covenants.
Default – The lender will have the right to call your line of credit facility if you default on any of your obligations or covenants under the agreement. Because the line of credit will be used to fund day-to-day operations, a sudden call on your line could effectively put an end to your business operations.
Payment – The terms of your loan repayment schedule will be outlined (for example, whether payments are monthly or quarterly, and whether payments are principal only, interest only, etc.). Interest is calculated on the outstanding balance of your advance.
Expiry Date – the expiry date of your facility will be set out. On or before this date, you may be required to renew the facility with your lender, or repay the balance in full.
Fees and Expenses – the fees and expenses the borrower has agreed to pay will be included in the agreement. For example, the borrower may agree to pay the lender’s legal fees and other expenses in connection with the payment of outstanding amounts or entitlements under the line of credit facility.
Covenants
The covenants provided in your line of credit agreement will vary depending on the type of facility you have and your business requirements. For example:
The list above is not exhaustive. Your bank may outline other covenants as well. The purpose of the covenants is to protect the lender. The lender wants to ensure that your business is being operated that will allow the business to generate sufficient revenue and cash flow to make any loan payments to the lender. The lender will want to make sure that your business is remaining solvent, which means your business has assets and liabilities, and that your assets exceed your liabilities.
How to Secure a Line of Credit
Obtaining a simple line of credit is comparatively easy. Typically, businesses obtain a line of credit through a local bank or other traditional lender. The bank will designate a banker to handle your request. In the same way you would apply for a business loan, the bank uses the same process for a line of credit.
The bank will look at criteria similar to a conventional loan, including solid business/financial history, adequate cash flow, and the ability to demonstrate the capacity for repayment based on the advancement of funds through the line of credit. The bank will also run a credit report on the business and its principals to determine their credit worthiness.
Although there are a variety of traditional lenders, most participants in a given market will offer similar terms based on risk levels. If you have competitive bids from different banks , be sure to focus on the actual costs and payment terms over the length of the line of credit. Avoid "teaser" rates that just kick the payments down the road to a later date.
Make sure when you deal with a banker that your line of credit is "revolving." Sometimes banks present alternative offers that are not standard. Be careful as renewal terms may end up not being favorable if you are expecting to renew or negotiate a higher amount down the road.
The bank will require the borrowing base report to aid in determining the amount available in the line of credit. You will have to provide documentation for receivables, payables, and equipment. Your bank may provide you with its own report form or make a request in a specific format.
Finally, request to be included on all statements, reports, or other information obtained from the bank. This will help ensure you have the proper back up materials to make adjustments.
Risks Involved in a Line of Credit
Just like with any contract, it is important to go through your line of credit with a fine-tooth comb and, if necessary, negotiate your terms. No term sheet is perfect. Any offer can be improved and negotiated.
First, let’s look at two of the biggest dangers of a line of credit: These two dangers are often interrelated. When I was an undergraduate taking my first finance course, I remember my professor showing us in a lecture how easy it is to manipulate the numbers on paper to make it look good for even the most dangerous investment. He even showed us the two danger points: when the interest rate reaches the principal and when your payments no longer cover the interest due. When that time is reached, the math demonstrates that you cannot pay the payment.
These two dangers are something that may happen down the road and are not likely to happen immediately. The more likely concern is that today’s interest rates may increase since they are very low right now. It might be difficult to make the minimum payment if the interest rate doubles.
It should be noted that lenders have thought of this and many times a line of credit will have a maximum interest rate or maximum payment cap. This doesn’t alleviate your concerns, however, as a line of credit can still be dangerous and has some definite disadvantages both in general and in comparison to other forms of financing.
The biggest consideration for many small business owners is the temptations associated with the ease of access to cash and the dangerous attitude such temptation can bring. Dealing with small businesses, I have seen business owners signing just about every piece of paper they were handed without reading or understanding what it involved. This is a difficult habit to break. Being so accessible, there is a risk that increasing the credit limit is too easy of a step.
From my experience, many small business owners view lines of credit as their "safety net" or simply put a large amount of faith into its existence. This comes with great risk as it can lead to overspending and ultimately losing control of their finances.
The best place to start is to have a personal relationship with the lender, be it a banker, angel investor, venture capitalist or some other person that is interested in the business. Though this is not always realistic or practical, it is worth exploring.
Line of Credit Compared to Other Types of Credit
When comparing a line of credit to other forms of credit, such as a personal loan or a credit card, there are both similarities and differences that may inform your decision on which product is best for your specific needs.
Similarities
A line of credit, a personal loan and a credit card may all be available through a financial institution, such as a bank or credit union. All three may be used to finance major purchases or cover unexpected expenses, funding general purchases in the case of a credit card. They can be considered short-term financing options, as they may be repaid in a relatively short period of time.
Difference with a Line of Credit
A line of credit requires a borrower to apply in advance and get approved for a specific amount. The bank or credit card company approves the borrower for a specific borrowing limit, and the borrower can draw on their line of credit up to this limit during a period of time that is specified by the financial institution, generally around six months to a year.
Difference with a Personal Loan
Different from a personal loan, credit cards and lines of credit allow borrowers to freely use their available balance (up to their limit) and make monthly payments at their own discretion. They can be used to make periodic purchases with varying amounts and timing. In contrast, a personal loan provides an individual with a lump sum of money up front, with which the borrower must then make regular payments over time according to a specific repayment plan.
Difference with a Credit Card
A line of credit allows a borrower to borrow up to a borrowing limit for a set period of time, and then repay with flexible credit. A credit card does not generally have a set period of time during which it can be used, allows you to borrow funds up to a limit, and gives you the option to borrow as frequently or occasionally as needed, as long as you stay below your limit. Furthermore, unlike a line of credit, a credit card may not have a specific interest rate on which it is based, where a line of credit typically has the interest rate based on the bank’s prime rate or some other national financial index.
Similarities with a Personal Loan and Credit Card
Personal loans, lines of credit and credit cards may offer low interest rates (especially for those with good credit), fixed interest rates, loyalty programs for on-time payments or other benefits, access to rewards points, discounts or special benefits. Depending on the terms of the product, borrowers can be given the ability to borrow more money from their account, so long as they’re within their personal limit.
Similarities with a Line of Credit and Credit Card
Lines of credit and credit cards are unsecured accounts, meaning that the lender does not require the borrower to provide any collateral that the lender may seize if the borrower stops making payments. Unlike secured financing, such as mortgages, there is no collateral backing.
Unsecured Accounts with a Line of Credit and Personal Loan
It is important to note that a personal loan may also be an unsecured account, where the borrower need not provide any collateral to the lender to secure his/her/its funding, similar to a line of credit and credit card.
Best Practices for Managing a Line of Credit
Regardless of the type of loan, developing a strategy for proper management is important for every borrower. The following tips will help you maintain your simple line of credit in good standing and potentially save you money.
Keep track of your balance If there is a positive balance in your line of credit, be sure to monitor it. When funds sit idle in a line of credit, borrowers are missing out on the opportunity to earn interest on their funds or invest them in opportunities that might have a higher return than the interest they are paying on their line. While it is a relatively simple matter to calculate the amount of interest you are paying on the line of credit, remember that the interest you are receiving on any funds sitting in the line of credit may be lower than what you would receive if you keep your money in a savings account. The best way to avoid earning unreasonably low interest on your funds is to track your balance and transfer it into an interest-bearing account when you don’t need it for an extended period of time.
Make payments on time Timeliness is key when it comes to making payments on your line of credit . If you miss a payment, your lender might increase your interest rate. Your credit rating also might take a hit. Always know when your payments are due and design a strategy to make sure they are paid promptly. Although some lenders require payments only once per month, bi-weekly and weekly payments are commonplace as well. Pay attention to your agreement to determine how often you are expected to make payments. Even if there is no required minimum payment, borrowers should make an effort to pay more than the minimum amount due. This can decrease the amount of interest accrued on the line of credit. Every situation will be different, but it is a best practice to pay more than the minimum wherever possible.
Try to avoid overdraft fees Check line of credit balances regularly to avoid overdraft fees. Your lender will charge you a fee if you spend more money than your line allows. Some lenders will charge this fee even if you are only a few dollars over your credit limit—so make sure you avoid overspending at all costs. Track your balance to be sure you remain within your limit and try to avoid trying to use your line of credit to pay off other lines of credit.