What is an Unsecured Line of Credit and How Does It Work?
Unsecured lines of credit :- Every business owner needs capital to run their day-to-day operations. Without adequate funds, the business might even come to a standstill. Getting a personal loan is one of the ways to gain access to the much-needed capital.
But because the need for capital might arise at unexpected times, a business always needs to be ready with funds to tackle those situations. Here’s where an unsecured line of credit can come in handy for business owners. Continue reading to find out all about this financing option.
An unsecured line of credit (LOC) is a revolving credit facility akin to a credit card. Here, a lender grants you access to funds up to a certain predetermined limit. You can withdraw funds up to the specified limit and use them to take care of your expenses, whatever they may be.
Interest is charged only on the amount withdrawn by you and not on the entire credit limit granted to you. Once a line of credit is granted to you, it can be used as and when you wish and for however many times you want as long as you repay the amount you borrowed along with interest and stay within the credit limit.
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Since an unsecured line of credit is, well, unsecured, you don’t have to pledge any asset as collateral to secure this facility. However, seeing as there’s no asset backing up the credit facility, lenders usually tend to charge a slightly higher rate of interest to offset the increased risk taken by them.
Now that you’re aware of what an unsecured line of credit is, let’s take a look at how it works using an example. Let’s say that you’re a business owner who is looking for quick access to funds. You approach your bank and request an unsecured line of credit. After thoroughly checking your eligibility, they grant you the facility with a credit limit of Rs.5 lakhs. The interest rate on the LOC is 18% per annum.
Assume that you require around Rs.2 lakhs to pay your employees their salary for the previous month. You withdraw the amount from the line of credit offered to you and use it to make the payment. Now, since you’ve used up Rs.2 lakhs, your available credit limit drops down to Rs.3 lakhs.
Let’s say that you decide to repay the borrowed amount 60 days later. You will be charged interest only on the amount borrowed by you, which is Rs.2 lakhs. And you will have to pay interest on it till the time you decide to repay it, which in this case is 60 days.
Interest = [(Amount Borrowed * Interest Rate) ÷ 365] * Number of Days Till Repayment
= [(rs.2 lakhs * 18%) ÷ 365] * 60 days = rs 5,918
As you can see from the calculation above, you will have to pay the borrowed amount along with an interest of about rs 5,918. Once you clear all the dues, your available credit limit will be restored to rs.5 lakhs.
Why is an Unsecured Line of Credit Perfect For a Business Owner?
With a traditional loan like a business loan, you get a lump sum amount upfront, which you can use to take care of your expenses. And you will have to repay it in monthly instalments along with interest over the chosen period.
Such a credit facility might be ideal for one-time use. Once you’ve exhausted the funds completely, you will be left with no other option but to apply for another loan to get access to more funds. However, not many financial institutions would be willing to grant you another loan while you’re still servicing one. The inability to access more funds can leave you and your business vulnerable.
With an unsecured line of credit, however, you won’t have to run into such issues at all. You can use the facility just like how you would use a credit card. You get the freedom to withdraw funds as and when you need them to satisfy your cash requirements. As long as you stay within the assigned credit limit, you can use your LOC to withdraw cash as many times as you want.
Even if you’ve exhausted your credit limit in its entirety, you can simply repay your dues, either in part or in full, to free up some credit limit, which you can use once again. This high level of flexibility and the fact that it requires no collaterals to avail it makes this unsecured line of credit the perfect choice for taking care of the expenses of a business.
Conclusion
With this, you must now be aware of what unsecured line of credit is and how it can help you, a business owner, handle your need for cash in a much better manner. While a line of credit is useful if you’re regularly in need of funds to manage your business, a business loan or a personal loan might be a better option for one-time use such as to buy a piece of equipment or for leasing premises.
That said, if you’re planning on applying for such loans to take care of your business expenses, remember to always use a business or a personal loan EMI calculator before you take the plunge. Doing so will give you an approximate idea of your debt obligations beforehand, allowing you to take an informed financial decision.
