What it means
Think of a line of credit as a borrowing allowance rather than a loan. The lender approves a ceiling, say $500,000, and the business can take what it needs up to that ceiling, pay it back and take it again without applying afresh each time.
Because interest accrues only on the drawn balance, a line of credit is far cheaper than a term loan for money you need briefly and unpredictably. That fits a business whose cash need moves week to week, such as one buying stock ahead of a seasonal peak.
The cost usually has two parts. Interest on what you have drawn, and a smaller commitment or non-utilisation fee on the part of the limit you are not using, which compensates the lender for keeping the money available.
Lines of credit come with conditions attached. Many are secured against receivables or inventory, most carry covenants such as a minimum current ratio, and many include a clean-down clause requiring the balance to reach zero for a stretch each year to prove the facility is funding working capital rather than losses.
The main risk is that availability is not guaranteed forever. Lenders can reduce or withdraw an undrawn line when results deteriorate, which is precisely when the business most wants it, so treating an unused facility as if it were cash in the bank is a dangerous habit.
In practice
Real-world examples
Example 1
A landscaping firm draws $80,000 each spring to buy plants and equipment, then clears the balance from summer invoices by August. Over the winter the drawn balance sits at zero and the firm pays only the commitment fee.
Example 2
A wholesaler waiting on a $300,000 payment from a large retailer draws on its line to meet payroll rather than delaying staff wages. The line is repaid the day the retailer's payment lands, costing three weeks of interest instead of a month of goodwill.
Example 3
A manufacturer breaches a minimum current ratio covenant after a weak quarter, and the bank cuts the available limit from $1,000,000 to $600,000. The business had been counting on the full limit for a machinery deposit and has to renegotiate the purchase timing.
Think of it
A line of credit is like a bottle of water you keep in your backpack on a hike. You do not drink from it all at once, and you do not pay for the water until you take a sip. It is there just in case you get thirsty, and you only consume what you need.
Formula
Calculation
Interest cost = drawn balance x annual interest rate x (days drawn / 365). Commitment fee = undrawn amount x fee rate x (days / 365).
Brightpath Foods holds a $500,000 line of credit at 9% interest with a 0.5% annual commitment fee on the undrawn portion. To buy stock for a festival season it draws $200,000 and repays it after 60 days.
Interest = $200,000 x 9% x (60 / 365) = $2,958.90. The undrawn portion during that period is $500,000 - $200,000 = $300,000, so the commitment fee for the same 60 days = $300,000 x 0.5% x (60 / 365) = $246.58. Total cost = $2,958.90 + $246.58 = $3,205.48.
That is 1.60% of the $200,000 borrowed for two months, an effective annualised cost of about 9.75% once the commitment fee is included. The headline 9% rate understates the true cost, which is why the fee structure matters when comparing facilities.Case study
Seen in the real world
Cedar Lane Outfitters is an illustrative, fictional outdoor clothing retailer with heavily seasonal sales: roughly 60% of its revenue arrives between October and December. Stock has to be bought and paid for from July onwards, so the business faced a predictable four-month cash hole every year.
Rather than take a term loan, the finance manager arranged a $400,000 line of credit. In a typical year the balance climbed to about $320,000 by late September and fell back to zero by early January, so the business paid interest for roughly five months instead of twelve.
In a slower year, the stock sold more slowly and the balance was still $150,000 in February, which triggered a conversation about the facility's clean-down clause. This fictional example shows both sides of a line of credit: it is an efficient way to fund a temporary need, and an uncomfortable one when the need turns out not to be temporary.
Watch out
Common mistakes
- Using a line of credit to fund long-term assets such as a building or a fleet, when a term loan matched to the asset's life is the appropriate instrument.
- Treating the undrawn limit as guaranteed cash in a crisis plan, ignoring that lenders can and do reduce facilities when performance slips.
- Comparing facilities on headline interest rate alone and overlooking commitment fees, arrangement fees and covenant conditions.
Questions
People also ask
What is the difference between a line of credit and an overdraft?
They are close cousins; an overdraft is attached to a current account and typically repayable on demand, while a line of credit is usually a separate facility with a defined term and documented covenants.
Do you pay anything if you never draw on the line?
Usually yes, in the form of an arrangement fee at the start and a small annual commitment fee on the undrawn balance.
Is a business credit card the same thing?
No, a card is a much smaller revolving facility at a far higher rate, useful for expenses rather than for funding working capital.