Extending lines of credit to your customers is different than accepting credit cards. When you accept credit cards, the credit card company assumes the risk of customers not paying their bills. But when you extend a line of credit—by allowing customers to make purchases for which they’ll be invoiced at a later date, for example—you assume that risk.
Even so, as your business grows you may at some point want to extend lines of credit to your customers. Before you do so, the Small Business Administration (SBA) suggests you consider the following issues:
1. The perks. When you extend credit to your customers, you are letting them pay over time rather than all at once. Often, this will allow customers to buy more than they would if they were paying in full with cash. A line of credit can also encourage customer loyalty because your customers know they will be able to make purchases from your business and pay over time.
2. The potential pitfalls. While there are benefits to extending lines of credit to your customers, there can also be drawbacks. As with any loan, there is the chance of default. Your customers could end up not paying the full amount owed to you, or they could go out of business and not pay you at all.
3. Your credit policy. Before you start extending lines of credit to your customers, you should establish a credit policy. Ideally you will set this up before you start offering credit. This policy can help you determine who should receive access to credit and let your customers know what to expect.
4. What “creditworthy” means to you. You will need to establish under what circumstances you’ll extend credit to your customers. To minimize the chance your customers will default on their payments, you may want to check their credit reports before allowing them to establish lines of credit with you. While this can mean fees paid to a credit reporting agency, it can also help protect you to some degree. A customer with a favorable credit history is more likely to repay the loan you offer and to make on-time payments.
5. How your customers will apply for credit. It makes sense to require an application from customers that want to establish a line of credit with your business. You can consider factors such as how long the customer has been associated with your business and the customer’s credit history, and you can even ask for credit references. By vetting the customers who wish to receive credit, you can help reduce your chances of getting stuck with a delinquent account.
6. Consumer credit laws. Once you have established a credit policy and payment guidelines, you need to make sure that you comply with consumer credit laws. These laws require you to clearly convey to your customers when they are required to pay, as well as when a payment is considered delinquent. The Federal Trade Commission (FTC) enforces these and other consumer protection laws, and you can find out more information about them on its website.
7. Payment collection methods. Some small businesses take care of billing and payment collection themselves, either by sending out invoices or depositing checks that have been held for a certain amount of time. However, this can become burdensome, and you may decide to outsource these tasks to another company. That way, professionals will take care of the payment collection and invoicing, and you will be free to concentrate on growing your business.
8. How you will handle late payments. If you choose to extend lines of credit, you have to consider what will happen if a customer pays late or defaults. Think about what the late penalties will be and what actions you will take if the loan is in default (reporting it to the credit agencies or turning the account over to collections, for example). Make sure that all of this information is spelled out in the credit agreement that your customers must sign.
Make sure you have everything in writing when you extend credit to customers. As you’re drawing up your credit policy, it’s a good idea to consult with a knowledgeable legal professional who can help you work out the right terms and language for your agreement.
Miranda Marquit is a freelance writer and professional blogger specializing in personal finance, family finance and business topics. She writes for several online and offline publications. Miranda is the co-author of Community 101: How to Grow an Online Community, and the writer behind PlantingMoneySeeds.com.