If you’re a commercial construction general contractor looking to ramp up operations, purchase construction materials, or cover labor costs, you may need to look into financing solutions like a construction line of credit or a business loan to cover the expenses to grow your business. Unfortunately, cash flow is a common issue in the construction industry, which prevents many construction business owners from paying invoices, purchasing equipment, or covering payroll expenses.
A line of credit may be a viable option to secure the working capital you need as a small business owner. Still, you should understand how they work along with the benefits and drawbacks before applying. There’s also an affordable alternative financing option to purchase construction materials worth exploring to help meet your construction company’s financial goals.
What Is a Contractor Line of Credit?
A contractor line of credit is a set amount of capital provided by a lender to help contractors fund operations.
How Does a Contractor Line of Credit Work?
You can withdraw as much as you need, up to the limit, during the draw period. Also, there are no restrictions on how you can use the funds, and you’ll make interest-only payments on the outstanding balance.
When the draw period ends, so will access to the funds. You will also begin making principal and interest payments on the outstanding balance for a set period.
Types of Contractor Lines of Credit
There are two primary types of contractor lines of credit: secured and unsecured.
Secured Lines of Credit
If you take out a secured line of credit, your company’s assets secure any withdrawn funds. If the contractor falls behind on payments, the company’s assets (up to the amount owed) can be seized and liquidated to cover the delinquency.
Your company may receive a higher line of credit and lower interest rate if it’s secured since the lender assumes less risk.
Unsecured Lines of Credit
Unsecured lines of credit come with higher interest rates and lower limits. However, the risk of default is passed on to the lender as you won’t have to put your company’s assets up as collateral to get approved.
Advantages and Disadvantages of a Contractor Business Line of Credit
Are you considering a contractor business line of credit? Before you apply, there are benefits and drawbacks to consider.
Benefits of contractor business lines of credit include:
- Flexible funding option: Contractors can access as much as they need, up to the line’s limit, at any time during the draw period.
- Affordable payments during the draw period: Lenders only require payments for interest while the line is still active.
- Easy to manage: You can pay off the outstanding balance at any time without incurring prepayment penalties. Or you can repay what’s owed during the draw period to avoid having to make a payment for both principal and interest when the line of credit closes.
Drawbacks of contractor business lines of credit include:
- Potential line of credit reductions: If your company routinely maxes out the line of credit or makes late payments, the lender could reduce the credit limit.
- Assets at risk: Secured lines of credit put your company’s assets at risk for seizure if you hit a financial bump and fall behind on payments.
- Higher payments during the repayment period: The monthly payments include both principal and interest once the draw period ends. Depending on how much you owe, this amount could be higher than the interest-only payments made when the line of credit was open.
How to Qualify for a Contractor Line of Credit
It may be simple to get approved for a personal line of credit if you have a strong score and a steady source of income. However, contractor lines of credit don’t quite work that way.
Lenders consider several factors when evaluating your application and deciding if you’re a worthwhile credit risk. Here’s what they look for:
- Company history: Is your company at least two years old? If not, the lender may require collateral to secure the line of credit.
- Company revenue: Are your company’s revenues sufficient to make payments on the size of the requested line of credit?
- Personal credit history: Is your personal credit health up to par?
Credit analysis ratios are also factored into the equation. These include:
- Debt Service Coverage ratio: This figure demonstrates the company’s ability to repay principal and interest on current debts with current operating income. Here’s the calculation: DSCR = Earnings Before Interest, Tax, Depreciation, Amortization / Interest + Principal.
- Debt to Equity ratio: This leverage ratio demonstrates the level of leverage shareholders and creditors have over the entity’s assets. Here’s the calculation: D/E = Debts + Fixed Payments/Shareholder Equity.
- Liquidity or Current ratio: This figure provides insight into the company’s ability to liquidate assets to meet short-term financial needs. Here’s the calculation: CR = Current Assets/Current Liabilities.
- Profitability ratio or Return on Assets ratio: This figure gauges the monetary return in net profit for every dollar invested. Here’s the calculation: ROA = Net Income / Average Assets.
You’ll also need to designate a guarantor to assume responsibility for the debt. Some lenders permit corporate guarantees, and others only allow a personal guarantee. If it’s the latter, this individual must agree to make any outstanding payments if the contractor defaults on the agreement.
How to Get a Business Line of Credit to Fund Your Next Construction Project
When you’re ready to get a business line of credit to fund your next construction project, start by shopping around with various lenders. Explore what each has to offer your company, and get pre-qualified to secure quotes with financing terms. Most importantly, compare your options to determine which may work for you and carefully review the covenants, or terms and conditions of your line, before you sign on the dotted line.
