How businesses use credit
No matter where your business is in its journey, there’s a chance that you may need to take out a loan or find other sources of financing to help your business grow.
Understanding how to use credit and the types of credit available to businesses may help you be an informed borrower.
“Credit” is another word for loan. When a business enters into an agreement to borrow money from another entity (the “lender”), the business is using credit.
In these agreements, the borrower promises to repay the lender over a specific period and those payments usually include a fee, called “interest.” The loan interest is calculated as a percentage of the amount borrowed, sometimes called the “principal.”
To get credit, borrowers need to demonstrate creditworthiness, or the ability to pay back the loan on time.
How could credit help your business?
One survey shows that 62% of small business owners use their personal funds to cover financial challenges.
There are many reasons why business owners apply for credit, but the most important reason is that a business loan frees you from having to dip into your personal funds to support company expenses.
What should you consider when exploring different credit options?
- What am I using the credit for? Knowing how you will use your funds may guide which type of credit you ultimately select. For example, there are loans that are designed specifically to purchase assets such as equipment and real estate.
- How much money do I need? Depending on your situation, lenders may allow you to borrow more money than you need. It’s important to determine exactly how much you need to borrow before applying for a loan to avoid over-borrowing, and thus, overpaying in interest.
- What are the terms of the agreement? Taking out a loan or using credit is a big step, and it is important that you feel comfortable with the repayment plan before you commit to any agreement. Be sure to do the math before signing an agreement so that your repayment plan is manageable.
- Do I expect that I will be able to repay the amount of credit I use (plus interest)? When considering this, consider whether your business is new or already well-established. This may be a helpful consideration when deciding the amount you feel comfortable borrowing, as well as the rate at which you will be able to repay the loan.
What are your credit options if you want short-term financing?
If you have small- to medium-size funding needs, you may want to consider a business credit card or line of credit.
Business credit cards: A business credit card operates just like a personal credit card, but often has a higher limit.
- Smaller purchases like office supplies
- Online purchases
- Can designate multiple authorized users
- Helps build business credit if managed responsibly
- May have lower eligibility requirements than other forms of credit
- Interest rates and annual fees could be high
- Personnel could misuse
- Late payments may affect business and personal credit
Lines of credit: Lines of credit work very much like a credit card with an approved maximum limit and interest charged only on the amount borrowed, but instead of a card, funds are transferred to the borrower’s banking account when needed.
- Even out cash flow
- Acquire inventory
- Take advantage of trade discounts
- Revolving credit*
- Gives you cash to work with
- Usually requires borrowers to have good credit and cash flow
- May require collateral
*Revolving credit means that funds are renewed once the original amount is paid off.
Many business credit cards offer the same rewards as personal cards and may be used to cover business expenses like travel and purchases.
What are your credit options if you want longer-term financing?
For larger loan amounts that require longer-term financing, businesses typically apply for term loans, which is credit given in one lump sum that must be paid back over a specified period. Businesses may also apply for loans specific to the asset that needs to be purchased, such as equipment financing (used to purchase equipment needed for business operations) or commercial real-estate loans (used for purchasing land or property).
These loans are repaid over a specified term which is defined by the loan contract. If an asset is expected to be purchased, it may be used as collateral for the loan.
- May be assisted by federal, state, and local small business loan programs
- Makes it possible to expand business
- Allows businesses to retain capital for emergencies
- Eligibility requirements may be high
- May require a down payment
- Interest rates and fees affect the value of the business
- May be subject to strict terms and restrictions
Five strategies to achieve a higher score
Since your credit score plays such an important role in obtaining credit, it’s important to maintain a strong credit history. The credit bureaus look at multiple variables when calculating your credit score and how each variable is weighted can vary.
These best practices can help you to maintain or earn a creditworthy score.
- Pay your bills on time.
- Avoid negative public records such as liens, collections, and bankruptcies.
- Don’t accrue too much debt.
- Diversify your debt.
- Check your score and report regularly and dispute any errors.
There are lots of important factors to think about as you go through the process of using business credit. Here are a few tips to consider.
- Choose carefully. There’s more than one type of credit, and you should make your selection based on your business’ specific needs.
- Know what to expect. In addition to repaying the amount borrowed, you may also pay interest and fees, and may need to provide collateral.
- Mind your score. Maintain a healthy credit score for your business by paying your credit obligations on time and checking your credit reports regularly.
- Understand your alternatives. Alternative credit options may be easier to get, but they are often expensive.
- Assess: Assess your business needs to pick a credit option that works best for you.
- Reach out: Talk to your local financial institution to learn more about the different credit options available.
- Build credit: Work on developing a positive credit history for your business to increase eligibility for lower interest loans.
The information in this article was obtained from various sources not associated with Adirondack Bank. While we believe it to be reliable and accurate, we do not warrant the accuracy or reliability of the information. Adirondack Bank is not responsible for, and does not endorse or approve, either implicitly or explicitly, the information provided or the content of any third-party sites that might be hyperlinked from this page. The information is not intended to replace manuals, instructions or information provided by a manufacturer or the advice of a qualified professional, or to affect coverage under any applicable insurance policy. These suggestions are not a complete list of every loss control measure. Adirondack Bank makes no guarantees of results from use of this information.
Article written by EVERFI