Financing and Capital Markets

Pay-Down Provisions in Short-Term Lines of Credit

Pay-Down Provisions in Short-Term Lines of Credit

Let’s say you are the owner of a company that manufactures a popular children’s toy. Your orders remain steady until retailers begin gearing up for the holiday shopping season in the fall, and then things pick up fast.

Whereas March may require only a skeleton crew, gearing up for a surge in demand in August means tripling your workforce. You also need to purchase more materials before your company has been paid. While sales are strong, you may not have the cash on hand to cover all of these expenditures.  

In short, you need an influx of funds to help you prepare for the spike in business. A short-term line of credit can help. Short-term lines of credit are designed to give businesses with seasonal or short-term needs access to a ready stream of funds that can be refreshed as the balance is paid off.   

Unlike long-term loans, for short-term lines of credit, banks often include a “pay-down provision,” which requires the borrower to bring the line of credit balance down to zero for a resting period of 30 to 60 days one time during the term of the line of credit.

So what are these pay-down provisions for and how can they benefit you?

Pay-down provisions ensure you receive the right kind of credit

Dev Strischek, senior vice president and senior credit policy officer at SunTrust Bank, says banks use the 30- to 60-day resting period to establish whether the line of credit is being used for seasonal needs or for longer-term working capital. 

If you as a borrower are able to “clean up” the line, then the seasonal line of credit makes sense. If you cannot clean up the line, that tells the banker your business really needs longer-term financing until it’s able to generate the cash flow from its investment in slower-earning assets.

“Sometimes with a fast-growing company there is some seasonality, but there’s a portion of the line that is really financing what we refer to as permanent working capital assets,” Strischek says. “That should be turned into a three- or five-year loan rather than require you to pay it all back in a year. Bankers try to match the term of a loan with the repayment ability of the borrower.”

Pay-down provisions in lines of credit help borrowers keep their spending to a reasonable amount, i.e. what they need. They also enable borrowers to have ongoing access to cash without having to pay interest on a longer-term loan. 

Lines of credit save on interest rates

Cutting down on interest can yield significant savings. For example, Strischek says, if a bank offered your business a $1 million loan at an annual 5 percent interest rate, you would pay $50,000 in interest over a year. On the other hand, with a line of credit, your business would typically pay interest only on the outstanding principal. That means if you use only 30 percent of the credit line over the course of a year, or $300,000 of the $1 million loan, the borrowing costs would be $15,000—a savings of $35,000. 

“Most borrowers would prefer to have a line of credit,” Strischek says. “You only pay for what you need.”

That said, Strischek says it’s important to make sure that the line of credit is large enough at the outset to accommodate your busiest period.

“Just make sure you provide your banker enough information so the bank can project how much credit you need in the busiest months of the year so you don’t have to come back,” he says.

He suggests borrowers provide their bankers with monthly financial information at least for the most recent year to give them the most accurate rendering of the business’s financial ebbs and flows. That ensures that the pay-down provision is compatible with your business’s needs.

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