This article is for educational purposes and does not constitute financial, legal, or tax advice. For specific advice applicable to your business, please contact a professional.
Being able to leverage credit as a business owner can extend your runway to reinvest in your business, hire staff, or manage cash flow. According to a recent Federal Reserve Small Business Survey, 31% of employer firms cited credit availability as a financial challenge for their businesses. As you consider what areas of your business could most benefit from an influx of capital, think about what types of credit might be best suited for its needs.
Open vs. Closed Credit
First, credit can come in two forms, open or closed. Open credit, also known as open-end credit, means that you can draw from the credit again as you make payments, like credit cards or lines of credit. Closed credit, also known as closed-end credit, means you apply for a set amount of money, receive that money, and pay it back in fixed payments. This can include things like a mortgage, appliance, or auto loan. Keep in mind there are some differences between your business and personal credit.
Below are different types of credit you may consider taking on as you grow your business.
Revolving credit refers to credit that is automatically renewed as you pay off your debts — it is a type of open credit. This means that there is no end date to this credit. Once you make a payment the amount of credit available to you goes back up. While all revolving credit is open credit, not all open credit is revolving. Typically if you do not pay your bill a balance will carry over to the next month and you can incur additional fees or charges.
Revolving accounts can include:
- Credit cards: Credit cards are payment cards that individuals can use to purchase goods and services. These cards are essentially a line of credit that can then be used to make purchases, balance transfers, and receive cash advances.
- Retail store cards: A retail store credit card is an offering you might typically see at the cash register of a retailer you frequent. While some store cards are loyalty cards and do not include credit, store credit cards do. Retail credit cards typically offer rewards that incentivize continued purchases at that retailer, such as reward points or cash back.
- Gas station cards: Gas station cards are commonly used to pay for gasoline, diesel, and other fuels. They can come in the form of credit or debit cards. In this case, gas credit cards would be considered revolving credit. In exchange for using this card, typically you could receive discounts on gas.
- Home equity line of credit or HELOC: A HELOC is a revolving credit that is secured by your property. Typically this comes with flexible repayment terms so you can continue to use the credit as you pay down the balance. This equity is determined by the share of your home that you own versus what you owe the lender on your mortgage.
Installment credit is a fixed amount of money that you borrow with an agreement to pay it off in predetermined increments until the loan is paid off. This type of credit is typically granted for things like durable goods and is a closed credit. If you default on payments, that good may go back to the seller or lender.
Installment accounts can include:
- Mortgage: A mortgage is an agreement between yourself and a lender that allows you to borrow money to purchase the home. These loans are used to buy a home or borrow money against the value of a home you already own. The Consumer Financial Protection Bureau (CFPB) says to look for these things when considering a mortgage loan.
- Auto loan: A car or auto loan, similar to a mortgage, is an agreement between yourself and a lender that allows you to borrow money to purchase a car. Much like a mortgage, the car is yours as you make payments.
- Student loan: A student loan is money borrowed from a lender or the government that allows you to pay for tuition, books, and other expenses related to education.
Bank credit is the amount of money you can borrow from a lender. In this case a bank determines how much they are willing to lend to you. This can come in two forms: secured (credit backed by collateral) or unsecured credit (credit that isn’t tied to any collateral). When it comes to working capital, this credit can be used to finance anything from materials to a mortgage. The defining feature of bank credit is that the borrower is taking on a loan from a financial institution.
Trade credit is a type of commercial financing that allows you to purchase goods with an agreement to pay the price at a mutually agreed-upon date in the future. This type of credit is commonly found in a business-to-business agreement.
Typically a business will give buyers 30, 60, or 90 days to pay for the purchase. This is referred to as net 30, net 60, or net 90, meaning you have that amount of days to pay the invoice. Sometimes these days only account for business days rather than calendar days so be sure to take the details associated with the agreement into account. One of the benefits to using trade credit is that you can build in an incentive for the customer to pay more quickly and better manage your accounts receivables. You could build in a discount of 2%, for example, if someone paid within ten or fifteen days of the 30-day window. This would then be communicated as 2/10 net 30 or 2/15 net 30 for those respective discounts. If the customer pays within those ten or fifteen days, they receive the discount for paying earlier. If not they still have thirty days to pay without a discount.
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How Different Types of Credit Affect Your Score
A credit mix includes all the different types of credit you have. This mix can include credit cards, different types of loans, and more. The Fair Isaac Corporation, more commonly known as FICO, looks at your credit mix as well as payment history to determine how that might reflect in your credit score. A FICO Score features a three-digit number that helps lenders assess your creditworthiness. The credit-mix portion of your FICO score is 10% of the overall scores.
While there are other ways to determine a credit score, FICO Scores are commonly used as a way to measure an individual or business’s ability to repay a loan. What this means is that if your credit score is not a FICO Score it could greatly vary in range.