Line of Credit: Smart Usage Strategies & When to Steer Clear

What is a Line of Credit?

Many financial institutions offer all in one or line of credit finance facilities. Simply put, a line of credit is a flexible loan from a bank or financial institution that acts as a loan and transaction account in one facility. These facilities allow businesses to draw funds as needed and repay them as cash flow allows, making it an ideal solution for fluctuating income or sudden financial needs.

Common uses include:

• Quick Access to Working Capital: Businesses often need quick access to cash to cover unexpected expenses or invest in opportunities requiring immediate funding.
  
  
• Managing Income Fluctuations: For businesses with seasonal or unpredictable income streams, a line of credit allows for reducing debt during high-income periods and redrawing funds when income dips.
  
  
• Financing Asset Purchases: Instead of going through the lengthy process of securing a new loan, businesses can use available funds from their line of credit to purchase additional assets quickly.

Case Study: A Lesson in Caution

While a line of credit can be a powerful financial tool if used for the right purposes and circumstances, we've often seen clients caught out where the use of their line of credit has been to  their detriment for tax deductibility.

Consider the following example:

A farming couple, Mum and Dad, who operate a successful cotton farming business, recently purchased a broadacre cotton property for $10 million, financed entirely through an all in one facility. Over the next few years, they had profitable seasons and reduced their debt to $2 million by using profits to pay down the facility.

However, when they decided to purchase a coastal home for $5 million, they used their available line of credit funds, raising their debt back to $7 million. They didn’t realise that the interest on the $5 million drawn for their private property would not be tax-deductible. This is because the interest deductibility is tied to the purpose of the borrowed funds—only debt incurred for income-producing purposes qualifies for a tax deduction.

This misstep highlighted a critical issue: When using a line of credit, the tax implications of how the funds are utilised can be significant.

Considerations for Smart Usage

To avoid falling into similar traps, businesses should keep the following in mind:

• Purpose Matters: Interest is only deductible if the borrowed funds are used to generate assessable income. Always ensure that any funds drawn from a line of credit are for business or investment purposes if you wish to claim a tax deduction.
  
  
• Avoid Commingling Funds: One of the most common mistakes is using a line of credit for both business and personal expenses. This can taint the deductibility of the interest, making it partly non-deductible. To preserve full deductibility, keep personal expenses completely separate.
  
  
• Understand the Terms: Before committing to a line of credit, fully understand how it works. Not all lines of credit are created equal, and some may not suit your business needs as well as others.
  
  
• Seek Professional Advice: Navigating the complexities of a line of credit and its tax implications can be challenging. Every business's financial situation is unique, and the rules surrounding tax deductibility can be intricate. To avoid costly mistakes, seeking advice from a qualified financial advisor or accountant like our accounting team at Synergy, who understands your circumstances, is paramount. We can help you structure your line of credit appropriately and ensure you maximise its benefits while complying with tax regulations.

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When to Steer Clear

While a line of credit can be a powerful financial tool, it's not the right choice for everyone. Before committing, consider these potential drawbacks:

1. High Interest Rates and Fees

Lines of credit, especially unsecured ones, often come with higher interest rates than other loan products. Additionally, some financial institutions charge maintenance fees and transaction fees each time you draw money, even if you don’t use the line of credit. The cumulative cost of these fees, combined with the interest that starts accruing immediately upon borrowing, can quickly add up, making this a costly option if not managed carefully.

2. Complicated Interest Calculations

The flexible nature of lines of credit allows for unscheduled borrowing and repayment, but this can make interest calculations more complex. If you're not vigilant, you might be surprised by how much interest you're ultimately paying. This unpredictability can be risky for those not financially disciplined or lack a thorough understanding of how interest on lines of credit is calculated.

3. Credit Score Requirements

Usually, securing a line of credit requires a good credit score. If your credit is less than stellar, you may struggle to get approved, or you might only qualify for less favourable terms, including higher interest rates. This could make repayment more challenging and more expensive in the long run.

4. Risk of Debt Spiral

Lines of credit offer easy access to funds, which can be tempting to use for non-essential expenses. Without a stable cash flow or a clear repayment plan, this can lead to a debt spiral, where the balance continues to grow, making it increasingly difficult to repay. If your business lacks the financial discipline to responsibly manage this type of credit, it might be better to explore more structured loan options.

Final Thoughts

When used correctly, a line of credit can be a strategic financial tool for businesses. However, it’s essential to approach it with a clear understanding of the potential risks and tax implications. By keeping personal and business expenses separate and ensuring that all drawn funds are used for income-producing activities, you can maximise the benefits while minimising the pitfalls.



If you have questions about effectively using a line of credit or need advice on whether it’s the right choice for your business, don’t hesitate to contact our office. We’re here to help you make informed financial decisions.