As the old saying goes, you need to spend money to make money – and that’s never truer than in business. Successful entrepreneurs borrow money because it enables them to expand and seize an opportunity when they spot a gap in the market. So, if you want your business to grow, there may come a point when you need to think about how you’ll finance it.
While taking on debt can seem scary as a small business owner, provided it’s properly costed and managed, it can be a sensible way to grow your business. Understanding the different types of credit available to you will help you make an informed decision around which option works best for you.
Open vs. closed credit
There are two main types of credit you’ll come across. Open credit refers to credit which you can keep drawing down from while also making payments to it – think credit cards or lines of credit with a supplier. Closed credit refers to a set amount of money with fixed payments and an end point such as a bank loan or mortgage. Keep in mind your personal credit and business credit will be different in some respects.
Types of credit available to small businesses
Revolving credit
Revolving credit is essentially open credit where you have an amount available to you which reduces as you use it and then opens again as you make payments. There’s no end date to this type of credit, it’s simply available for you to use as and when you need it. However, if you don’t make the minimum payments on time, then you may be subject to late payment fees or additional charges and the balance will carry over to the following month.
Revolving credit can include:
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Business credit cards – business credit cards work in the same way as a personal credit card although they’re designed to be used by the business rather than individuals. You can use a credit card to pay for goods and services, make balance transfers and organise cash advances. They are available to businesses of all sizes and can be used to help build up your business credit profile. They can also be used to manage employee expenses and you may receive additional benefits such as travel insurance or cashback on purchases.
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Store cards – these are declining in use. They work like credit cards, except you can usually only use them in a specific store. You can purchase items on credit and pay off any balances in full. If you don’t pay the balance each month, you’ll be subject to interest charges. This type of card often offers incentives to encourage you to shop in-store.
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Fuel cards – you use this type of card to pay for fuel for your business vehicles and usually receive an invoice at the end of the month. You can give your employees a fuel card to use rather than relying on a company credit card or reimbursing employee expenses.
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Home equity line of credit (HELOC) – this type of credit is secured on the equity in your property. You’ll have credit based on the amount of equity available. It usually comes with flexible terms so you can continue to use credit while paying down the balance.
Instalment credit
This is typically a closed amount of credit over a fixed term and is paid off by a set of predetermined payments. You’d usually find this loan tied to the goods you’re paying for, so if you default on the loan, the lender can repossess the goods in question, for example a car or a piece of equipment.
Instalment credit can include:
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Mortgage – a mortgage is in essence a bank loan which allows you to buy a property by borrowing against the value of that property. A mortgage is typically secured on the property so if you default on payments there is a risk it will be repossessed to pay your debt.
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Car loan – like a mortgage, a car loan is an agreement between you and the lender which lets you borrow money based on the value of the vehicle in order to purchase that vehicle.
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Equipment finance – this type of loan enables you to pay for major business equipment and is usually secured upon the equipment. For example, if you need to purchase office furniture, computers or heavy machinery you might use this type of credit.
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Square Loans – A Square loan is a type of instalment credit but whereas the above loans usually involve fixed repayment, Square gives you the flexibility to set the amount you wish to pay each month and will base the amount you’re offered on your day-to-day sales data. Typically, you’ll have 18 months to repay your loan and can pay it out of your daily sales – more on the days when you’re busy, less when business is slow.
Bank credit
Bank credit covers money you can borrow from a high street lender or financial institution who will use certain criteria to decide how much they’re willing to lend you. This comes in two forms: unsecured and secured.
Unsecured credit - No collateral is required to get the loan. Typically, this applies to smaller amounts.
Secured credit - An asset or property will be used as collateral which means if you default on the loan, you risk losing that asset or property to pay your debt. Usually, this is applied to larger-sized loans but will depend on individual lenders.
Trade credit
This will be an agreement you have with your suppliers where you receive goods or services on credit and pay for them at a mutually agreed date in future. For example, if you run a bakery, you might order your ingredients from a wholesaler weekly and pay for them at the end of each month. It’s a common business agreement.
You’ll typically be given X number of days to pay your debt each month e.g., 30 days, 60 days or 90 days. Some businesses offer incentives if you pay earlier than your due date such as a small discount.
How different types of credit affect your score
Credit scoring is a commonly used way to assess the risk of lending money to people and businesses but there is no one single credit score. There are three main credit agencies in the UK – TransUnion, Experian and Equifax – and all will hold and use different information to create your credit score.
The main things that affect your credit score are:
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Borrowing history – if you’ve little to no experience borrowing it may show a low credit score even with a good income. Having active credit accounts for some length of time however, can indicate you can manage them responsibly.
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Range of credit – having a wider range of credit options on your score can indicate an ability to manage debt responsibly. For example, having an overdraft, unsecured loan and a credit card.
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Repayment history – any late or default payments will be reflected in a lower credit score.
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Joint accounts – mortgages, loans and even utility bills can create financial links with someone else which can impact your own credit score.
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Balances – if you already have a lot of credit and are close to the limits this can suggest you rely on credit and may reduce your overall credit score.
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Moving house – being on the electoral register and at the same property for a long period of time can improve your credit score – it suggests to lenders your circumstances are stable.