A business owner is often subject to various factors that cause financial uncertainty or instability - this can happen in almost any industry, but especially for a small business. The truth is, these dips of uncertainty have the potential to bring a small business to its knees, but that doesn’t have to be the case if you take the right precautions. 

One of the first ideas that comes to mind for fast cash, besides smashing your kid’s piggy bank, would be a business loan. But what if you can’t afford a regular business loan, or aren’t sure you need the full loan amount? That's where a business line of credit comes in.

What is a Line of Credit and How Does it Work?

A line of credit (LOC) is a predetermined borrowing credit limit that is arranged by a financial institution and their client. The maximum amount of credit is determined by basic business information such as credit score, the relationship held between the borrower and lender, personal assets, and other particulars. 

The borrower can continue to borrow money for as long as the limit allows. Once money is repaid to the line of credit, that amount can be borrowed again in the case of a revolving line of credit. Non revolving lines of credit do not replenish after payments are made; once you pay off the line of credit in full, the account is closed and cannot be used again.

An LOC is a fixed amount of money that clients can withdraw from whenever they want; the amount a client chooses to withdraw from the total lump sum is up to them (the borrower does not need to use the full amount of money if they don't wish to). With an LOC the client gets built-in-flexibility, meaning they only have to repay - and pay interest rates on - whatever amount they take out, not on the entire credit line (particular rules may vary depending on the institution). 

One perk of using a line of credit, is the ability of the borrower to adjust their repayment amounts based on their current budget and cash flow. Such flexibility allows borrowers to pay the entire outstanding balance if they so wish, or opt to make only the minimum monthly payments. 

That being said, the interest percentage, payment sizes, and other loan terms are set by the lender. 

Who Needs a Line of Credit? 

Small businesses must be able to adapt to change, especially so when they are growing or dealing with uneven cash flow. In either instance, when the business needs to be able to access readily available funds with flexible borrowing terms, then a line of credit can be the ideal solution. 

A note to remember is that most lenders will want to see a detailed business plan and financial performance before lending funds, so do your best to have those prepared. 

 Here are some examples of the types of businesses that could benefit from a line of credit: 

• Start-up businesses that need help getting started
• Small businesses who are going through a rough patch 
• Seasonal business
• Established businesses who are experiencing a lapse between doing the work and getting paid

When Should Businesses Use a Line of Credit? 

A line of credit can be used to ease a business owner on the vagaries of variable monthly income and expenses or to finance projects where it may be difficult to precisely identify the funds needed in advance. An LOC is one of the tools a business can use to finance working capital requirements, such as:

• Purchasing inventory
• Repairing business-critical equipment
• Financing a marketing campaign
• Bridging a seasonal cash flow gap

Should your business need to access funds regularly to meet capital needs for managing the business’ day-to-day capital requirements, then applying for a LOC will make sense for you. Here are a few examples where it would be a good idea to open a line of credit: 

Example 1

A self-employed individual who has an irregular monthly income or who experiences unpredictable delays between performing the work and collecting the pay. This person might usually rely on credit cards to deal with the cash-flow crunches, a line of credit can be a cheaper option as it normally offers lower interest rates, and provides a more-flexible repayment schedule.

An LOC can also help fund estimated quarterly tax payments, particularly when there is a discrepancy between the timing of the “accounting profit” and the actual receipt of cash.

Example 2

Suppose a small business is looking for funds to finance a new marketing campaign. This marketing campaign could attract new customers and improve sales, making it a necessary expenditure. In this case, the borrowed funds could easily be paid back in full as the campaign would create additional revenue. 

Example 3

Some businesses have to deal with late invoice payments. Perhaps the businesses could use a line of credit to cover business and operating expenses until the clients pay off their outstanding invoices. In this case, a LOC can help with this cash flow problem.

What Determines Business Line of Credit Interest Rates?

The lender extending the LOC will evaluate your business bank account, profitability, and business cash flow, in order to determine the line of credit limit and interest rates (they may also ask to see a business plan). Depending on the amount of credit requested by the business, the lender may decide on a secured or unsecured LOC. Lenders will look to the business’s financial records and historical data to determine its creditworthiness. Almost all LOC interest rates are variable. 

Here are some factors that will determine a business line of credit interest rates: 

1. Businesses financial health 

The lender will be interested in seeing your business’s income statements to determine its current financial position and performance. They will look at the revenue, expenses, and profits earned by the business within a period of time. 

Since the income statement illustrates a company’s earned revenue, gross profits, business expenses, and net profit, lenders will get a good idea of the business is in a position to pay back credit. 

2. Prime rate 

The prime rate in Canada is currently 2.45%, which is the interest rate that banks and lenders use to determine the interest rates for many types of loans and lines of credit. It is primarily influenced by the policy interest rate set by the Bank of Canada (BoC)

When you apply for a loan with a variable interest rate, your lender will give you an annual interest rate that’s tied to the bank’s prime rate - many types of loans are based on this rate. 

You think of the prime rate as the anchor these other interest rates are based on. As the prime rate moves up or down, so does the rate of interest you pay on your loan.

3. Personal credit score 

Personal credit is what you build by showing trustworthiness when it comes to paying your bills on time and in full, from credit cards to automobile loans to home loans. Any personal loans will affect your personal credit score. 

A good credit history and score says a lot about how financially responsible you are. It’s a reference point used by lenders to determine how risky a borrower you might be. Credit scores are calculated by two Canadian credit bureaus: Equifax and TransUnion. A credit rating may range from 300 to 900, and typically lenders set a minimum credit threshold for their clients - this number is not universal, it changes from lender to lender. Typically, your credit history will determine the rating. 

4. Business credit score 

In comparison to the personal credit score, a business credit score is directly tied to your business bank statements and financial statements. A good business credit score will help to demonstrate to lenders, suppliers, and vendors that you are a good candidate for a LOC, and whether or not you can be trusted to pay back your business-related expenditures on time. Again, the rating you receive will depend on your business credit history.

5. Loan features 

Loans come with different features that can change the security of the loan, the payments on the loan, and the interest rate of the loan. The main features include secured versus unsecured loans, amortizing versus non-amortizing loans, and fixed-rate versus variable-rate (floating) loans.

6. Industry 

Interest rate levels will factor into the supply and demand for credit within the industry. An increase in credit demand will raise interest rates while a decrease in demand will lower interest rates. At the same time, an increased supply of credit will reduce interest rates, while a reduction in credit supply will result in an increase in interest rates. 

At lower interest rates, the marginal efficiency of capital increases. This means when it is cheaper to borrow – more investment projects are likely to give a return greater than the cost of debt interest payments.

On the other hand, high interest rates may encourage firms to save cash rather than invest, as they can make a good return from just putting money in a bank. At lower interest rates, firms have less incentive to save.

7. Age of business 

Lenders may see younger businesses as higher risk because they don’t carry the same years of experience as a more established business. Therefore reflecting the amount of interest they are charged.

How is Interest Calculated on a Business Line of Credit?

A business line of credit uses the simple interest method instead of a compounding method. Follow this formula for calculating simple interest on a line of credit: 

Daily Interest Rate X Principal Amount Borrowed X # of Periods= Simple Interest

Making a payment towards a simple interest loan means that the payment will first cover the month’s interest, and whatever is left over will go towards the principal. This payment on each month’s interest should cover the full amount, so it never accrues. In comparison, when you pay compound interest, some of the monthly interest is added back onto the loan. In this case, you pay new interest on old interest with each succeeding month. 

Additionally, interest on a business line of credit can be calculated using the average daily balance method. This method calculates the average balance by multiplying the amount of each withdrawal made on the line of credit by the days remaining in that billing period. The resulting amount is then divided by the billing period’s total number of days to determine the average daily balance of each withdrawal. The sum of these average withdrawals is then added to any pre-existing balance, while the average daily amount of withdrawals on the account is subtracted. This calculation will leave you with the average balance, which is then multiplied by the annual interest percentage rate (APR).

Business Line of Credit Rates with Common Canadian Lenders

Here is a list of Canadian financial institutions that offer business lines of credit, as well as some key features and benefits of each.

CIBC

• Interest rate: Variable 
• Line of credit amount starting from $10,0001
• Secured and unsecured options 
• Monthly fee: $25 - $125
• Set up fee: $150 -$1000
• Repayment: variable 
• Requirement: making the minimum interest payment each month

Scotia Bank

• Low interest expenses thanks to exact dollar borrowing 
• Competitive floating interest rate with the use of Scotiabanks’s prime lending rate 
• Unsecured business Credit Lines, with limits up to $1 million

• Repayment: Minimum 3% of the monthly balance
• Optional Comprehensive Insurance

TD

• Access to cash for business expenses: rent, inventory, payroll, daily operations
• Amounts available: $5000 - $500, 000. 
• Rate type: variable 
• Flexibility: Pay as little as the minimum payment requirement as set out in your Line of Credit Agreement, or any greater amount up to the entire balance.
• Your line of credit can be paid down and used again

BMO

• No monthly or annual review fees
• No application fees
• Competitive rates
• Flexible repayment options

RBC

• Once you pay down your balance there is no need to re-apply.
• Make just the minimum payment, or pay more to reduce your balance. You can also make changes to your payment account, payment amount, payment frequency or payment due date through RBC Online Banking.
• No annual fees. Additionally, there is no fee to withdraw funds and they do not charge over limit fees on Royal Credit Line accounts.
• They offer secured and unsecured lines of credit

Thinking Capital

• Needs-based withdrawals within a pre-approved limit
• “Revolving” credit that becomes available again as you make payments. With even the possibility of increasing the credit limit. 
• Only the draws you make are counted as loans in your credit history—not the total pre-approved limit
• Flexible repayment schedules with daily, weekly or bi-weekly payment options, with the ability to pay early to save on interest
• Borrow $500 to $300,000, with 2 to 12 month term options, and absolutely no hidden fees.

Alternative Lenders for a Business Line of Credit 

An alternate source to a business line of credit is a Business credit card, as they can be a good way to manage and itemize business expenses. Business credit cards typically have unique benefits designed to entice business customers, differing from the benefits. offered to individual customers. For example, credit cards provide cash back on purchases at stores that businesses are likely to shop at, such as office stores, or offer larger sign-up bonuses to secure new customers. 

Another common benefit to business credit cards are the travel perks that come with them, as many financial institutions understand businesses can wrack up significant travel expenses. For example, a business credit card holder may gain access to an airport’s VIP lounge or obtain discounts on hotel stays when traveling for business.

However, business credit cards normally have slightly higher interest rates than lines of credit. This is because credit card debt is generally unsecured, creating a higher risk for lenders. 

For that reason, many business credit card agreements will include a personal guarantee provision regardless of the business’s credit score, so ensure that you read the fine print and understand the full terms of the agreement. If the lender implements the personal guarantee provisions, then any delays on the card could be reported on the individual’s credit report and damage their credit score.

Additionally, third party lenders may also be used for lines of credit. A third-party lender is an establishment that provides financing and loans to businesses or customers by taking on the risk of default (they could also be known as online lenders) 

Third-party lenders come in many forms and functions. They can provide lines of credit for businesses with good payment histories who want temporary access to capital but don't want long-term debt.

These lenders can also provide short-term emergency funds to those with financial troubles who might not otherwise be able to secure loans from a traditional financial institution. If an individual is declined credit at a bank, they can turn to a third-party lender to obtain the funds they seek. 

At the same time, third-party lenders can provide greater flexibility in their contracts and support a wider range of financial needs. Such lenders can also offer lower rates for small businesses than banks in certain cases, and you usually receive your money the next day. 

Staying on top of your finances is a measure you can take to keep your business line of credit interest rate low. QuickBooks Online will give you the tools you need to keep track of loan payments and ensure your business stays in good financial standing. Try it today.