Lines of Credit in Construction: The Pros & Cons for Contractors

In the construction industry, contractors often spend large sums of money on materials and other project expenses before they actually get paid for their work. This situation creates a significant gap between spending and earning. To tackle this challenge, many contractors turn to financing options to cover their project expenses — bridging the gap until payments start coming in. 

Opening a bank line of credit is a popular choice among the various financing options available to contractors, but it’s important to determine whether a line of credit is the best option for your business. In order to make an informed decision, you need to know how they work, explore recommended use cases, and weigh the pros and cons. 

What is a bank line of credit?

A bank line of credit is a financial tool that a borrower can draw money from as they need it. Borrowers can withdraw and pay back the money as many times as they want, and interest only accrues on the amount that they withdraw.

A bank line of credit can either be secured or unsecured. 

• With an unsecured line of credit, a contractor does not have to provide assets as a guarantee that they’ll repay the loan. Because of this, it’s considered riskier and carries a higher interest rate.
• A secured line of credit requires collateral, such as a contractor’s property or assets, as “security” to guarantee reimbursement. If they default, the lender can claim and sell the collateral to recover their funds. Secured bank lines of credit offer higher credit limits and lower interest rates. 

Pros & cons

Contractors considering a bank line of credit need to consider the benefits and disadvantages before applying. 

Pros

Courses about construction.
For construction.

Unlock your career potential with our free educational courses on Health & Safety, Data in Construction, and more.

Learn More

Cons

Qualifying factors

Lenders consider multiple factors when evaluating an application and deciding if a contractor is a worthwhile credit risk. Two primary factors include company history and business revenue. 

If a company is younger than two years old, it will typically be considered high-risk, and the lender may require collateral to secure the line of credit. And because revenue is ultimately the source of funds to repay the lender, they will want to see that a company has sufficient revenue in order to justify the size of the line of credit.

In addition, banks evaluate several credit ratios during the assessment process that indicate the company’s ability to pay back the debt. 

A business will also need to designate a guarantor to assume responsibility for the debt in the event of default. 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. 

Best practices for contractors

As a general rule of thumb, it’s always best to reserve a bank line of credit for emergency situations. Contractors should try to avoid the risk of maxing out their credit limit or missing payments, both of which could damage their credit scores. 

If a contractor determines it is best for the business after weighing the pros and cons, then there are some key best practices for managing the bank line of credit.

1. Maintain a clear purpose: Use a bank line of credit primarily for operational expenses and critical business needs, rather than relying on it for all purchases.
2. Plan strategically: Carefully assess the business needs and only utilize the bank line of credit when there is a clear plan for revenue generation or to cover essential expenses.
3. Track the budget closely: Develop a detailed budget that includes the bank line of credit usage. Regularly monitor and track expenses to ensure they align with the allocated funds and avoid overspending.
4. Borrow responsibly: Borrow only the amount necessary and maintain a disciplined approach to managing credit. Avoid the temptation to max out the bank line of credit and use it sparingly for critical needs.
5. Make timely payments: Make payments on time to maintain a positive credit history and enhance creditworthiness. Whenever possible, strive to pay off the balance in full to reduce interest charges.
6. Keep a close eye on cash flow: Effectively manage cash flow to minimize the reliance on the bank line of credit. Maintain a healthy working capital position by optimizing revenue collection and controlling expenses.
7. Get professional advice: Seek guidance from financial professionals or advisors who specialize in the construction industry. They can provide valuable insights and help a contractor make informed decisions regarding their bank line of credit.

Written by