Business term loans are a traditional form of financing where a lender provides a lump sum of capital to a business, which the business must repay with interest over a predetermined repayment schedule. The “term” in “term loan” refers to the fixed period during which the borrower must repay the loan. This period can vary depending on the specifics of the agreement but typically falls under one of three categories: short-term, intermediate-term, or long-term.
Typically, term loans are amortized, meaning that each periodic payment (usually monthly) is the same amount throughout the term and includes both principal and interest. By the end of the agreed term, the entire loan balance should be repaid in full.
The provision for end-of-term balloon payments (larger than usual final payments) or variable repayment structures can also exist depending on how the terms have been negotiated between the lender and borrower. Security for a term loan can be provided by collateral such as business assets or a personal guarantee.
Interest rates for business term loans may be fixed or variable; a fixed rate is set for the life of the loan, whereas a variable rate may fluctuate based on changes to an underlying interest rate index.
Business term loans are normally used to finance long-term investments or consolidate existing debts. They differ from revolving credit lines and types of alternative financing that offer more flexible borrowing and repayment terms. The structure of a business term loan advocates financial planning and stability through predictable repayment plans.
Types of Business Term Loans
Business term loans can be segmented according to the length of their repayment terms. The category of a term loan directly corresponds with the period allotted for repayment, and each has its unique characteristics ideally suited for different business needs. Here’s how they break down:
Short-term Business Loans
Term Less Than 1 Year
Short-term loans offer quick cash that’s usually repaid within less than a year. They’re particularly beneficial if your business requires immediate financing to capitalize on a momentous opportunity or cover unexpected costs. However, short-term business loans generally carry higher interest rates as compensation for the lender’s increased risk.
Intermediate-term Loans
1 to 5 Year Repayment Term
If your business is undertaking a moderate investment, such as minor expansions or equipment upgrades, an intermediate-term or medium-term loan can be the best choice.
These term loans are repaid over a period of one to five years, striking a balance between lower payments than short-term alternatives and fewer interest obligations compared to long-term loans.
Long-term Business Loans
6+ Year Term Length
When your business plan calls for a major expansion, large-scale equipment purchases, or significant investments in property or infrastructure, long-term business loans offer an extended repayment timeline that can extend beyond six years. Their longer duration allows for more manageable periodic payments, but it also means that you’ll likely pay more interest over the life of the loan.
Reasons to Choose a Business Term Loan
Term loans are a popular financing option for businesses for several reasons:
1. Predictable Payments
Term loans offer the certainty of fixed payments. This makes budgeting easier for businesses as they can plan ahead for consistent repayment amounts.
2. Defined Repayment Period
The fixed duration of a term loan means that borrowers know exactly when the debt will be paid off. This allows for long-term financial planning and the setting of clear debt reduction goals.
3. Large Loan Amounts
Typically, term loans offer access to larger amounts of capital compared to other types of financing options such as lines of credit or credit cards. This makes them suitable for significant investments.
4. Lower Interest Rates
Due to their secured nature and longer repayment terms, business term loans often feature lower interest rates than unsecured loans or short-term financing options, resulting in lower overall costs.
5. Collateral-Lead Security
With a term loan, lenders may allow collateral, such as property or equipment, to secure the loan, which can also contribute to more favorable borrowing terms including potentially lower interest rates.
6. Boost Credit History
Successful repayment of a term loan can help establish and improve a business’s credit history, making it easier and often more affordable to borrow in the future.
7. Flexibility
Though less flexible than revolving credits, some term loans offer flexibility such as periodic repricing, the ability to pay off early without penalty, and restructuring options if necessary.
Term loans are appealing to businesses because they provide better control over cash flow and enable significant investments in growth. Unlike lines of credit, which can have variable volatility, or high-cost short-term options, term loans offer stability and affordability.
Uses of a Term Loan
Using a term loan strategically can allow you to undertake major projects or address essential needs that will drive your company forward. It’s vital that the way you choose to use the funds aligns with your wider business objectives and the agreed repayment plan is sensibly structured so your company can repay it.
A term loan can equip your business with the necessary funding for various strategic initiatives. Here’s how you might choose to apply a term loan for your company’s benefit:
Business Expansion
If you’re aiming to widen your market reach by opening new outlets or enhancing your production capabilities, a term loan can provide the substantial capital required for such growth endeavors.
Purchase Equipment
If your business needs new equipment or machinery, a term loan can help finance these major investments without straining cash flow.
Inventory Management
Should your business need to stock up on inventory ahead of high-demand seasons, a term loan allows you to make these sizable purchases, maintaining a steady supply for customer demands.
Staffing and Recruitment
To not only sustain but also scale your business operations, investing in human capital through hiring efforts can be facilitated with the resources from a term loan.
Debt Refinancing
Exploring better interest rates or consolidating several debts into one regular payment is possible with a term loan, optimizing your business’s financial commitments.
Property Investments
Whether it’s purchasing additional office space or a new storefront, real estate acquisitions can be realized using the funds from a term loan suited for large-scale capital investments.
Enhance Working Capital
Utilizing a term loan can give your business an essential infusion of working capital to support the day-to-day operational needs, keeping everything running smoothly even during varying sales cycles.
Business Term Loan Costs & Fees
Securing a term loan involves various costs and fees, which are added expenses on top of the interest rate. That’s why it’s critical to understand each one and consider them in your cost-benefit analysis when securing funding for your business.
Transparent lenders will outline the costs upfront to avoid any hidden surprises down the line. Always make sure to ask about any additional charges that may apply during the life cycle of your business term loan so that all possible expenses are accounted for in your financial projections.
The disclosed fees will differ from lender to lender; however, here are some common costs that you might encounter:
| Fee | What it's for | What it can cost |
|---|---|---|
| Origination Fee | Processing a new loan | 0.5% - 5% of total loan amount |
| Application Fee | Submitting a loan application | $25 - $350 |
| Service Charges | Account maintenance and management | $10 - $50 per month |
| Prepayment Penalty | Compensate lender for early loan payoff | Several months’ interest or % of balance |
| Late Payment Fees | Delays in repayment | Flat fee ($30 - $50) or percentage (3% - 5%) |
| Guarantee Fee | Backing by SBA or third-party guarantor | 0% - 3.75% of guaranteed portion |
| Collateral Appraisal Fees | Property valuation for collateral | Several hundred dollars |
| Closing Costs | Legal and filing paperwork | $2,000 - $5,000+ |
| Packaging Fee | Third-party services for securing financing | $2,000 - $4,000 |
| Wire Transfer Fee | Covers bank fees for funds transfer | $10 - $75 per transfer |
| Renewal Fees | Extending or renewing term loan | Varies widely, inquire with lender |
| NSF / Bounced Check Fees | Checks drawn on insufficient funds | $15 - $35 per incident |
How Business Term Loans Work
Understanding the workings of a business term loan can shed light on whether this type of financing is suitable for your business needs. A typical business term loan involves the following steps:
- Application Process
To initiate a term loan, your business first completes an application with a lender, which requires providing detailed information about your business’s financial health, credit history, profit margins, and other relevant documentation. - Approval & Terms
Once your application is reviewed, the lender will either approve or deny your request based on their lending criteria. If approved, the terms of the loan—including interest rate, repayment schedule, fees, and other loan covenants—are presented to you. - Funding
Upon agreeing to the terms and signing the loan documents, the lender will disburse the funds as a lump sum to be used for purposes as defined by you during the application process. - Repayment Schedule
The repayment schedule stipulates when and how often payments are due—typically monthly. The amount includes both principal and accrued interest calculated over the agreed loan term. - Amortization
Most business term loans are amortized, which means that early payments consist mostly of interest, while later installments primarily pay down the principal balance. - Loan Maturity
When all scheduled payments are made successfully, your loan matures—indicating full repayment. If a balloon payment was part of the agreement, it would be due at this time. - Additional Services and Management
Throughout the life of your loan, you may access additional support services offered by your lender to monitor and manage your loan effectively, including online account management and customer service assistance.
Is a Term Loan is Right for You?
Deciding whether a term loan is the right financing option for your business requires a thorough analysis of your financial situation, as well as an understanding of your short-term and long-term objectives. Here are some considerations to help guide your decision:
What’s the Purpose of the Loan?
Assess what you’re aiming to finance with the term loan and ensure it aligns with your business plan and projected growth.
Analyze Your Business Cash Flow
Look over your past financial statements and cash flow forecasts to evaluate whether you can consistently cover loan repayments without causing a burden day-to-day operations. Be sure to consider seasonality.
Consider the Term Length
Understand how the term length associates with your investment timelines. Short-term needs may not warrant a long-term loan due to potentially higher overall costs of borrowing.
Evaluate Repayment Terms
Look at the frequency of repayment, total number of payments, and possibility of balloon payments or penalties matching against your cash flow cycles.
Interest Rate Impact
Consider how fluctuating interest rates might affect payment amounts over time, especially if you’re contemplating a variable-rate loan.
Fees and Additional Costs
Factor in all upfront and ongoing fees, penalties for late payment, prepayment penalties, and any other costs associated with the loan to get a full picture of affordability.
Assess Funding Speed
Understand how quickly you need funds; term loans have longer processing times compared to alternative business loans which may not be suitable for urgent funding requirements.
With a business line of credit you can get funds in as little as 24-hours.
Collateral Requirements
Ensure you are comfortable with what assets must be pledged as collateral (if required), and understand the consequences should you default on the loan.
Weigh Alternate Financing Options
Compare term loans and other financing products like lines of credit, merchant cash advances or factoring services considering flexibility and cost-effectiveness in context with your goals.
Get Advice from Financial Experts
Talking to an accountant, financial advisor, or business consultant can provide insightful guidance tailored to your situation. They can help you model the costs for different types of loans to make sure you make the best decision for your business.
Don’t Use a Term Loan if…
Deciding to pursue a term loan is a significant financial decision for any business owner. While term loans can provide capital needed for growth and development, there are scenarios where this form of funding might not be the best choice.
- Your business has inconsistent cash flow
- Unclear purpose or mismatch with business strategy
- More affordable financing options are available
- Need for borrowing flexibility is greater than what a term loan offers
- Unwillingness or inability to collateralize the loan
- Loan-associated fees outweigh potential benefits
- Your business is already carrying substantial debt
Be sure to reflect on your company’s fiscal health, immediate needs, and long-term goals before taking on any form of financing.
Prepare for a Business Term Loan
Preparation is key when approaching a business term loan. A well-prepared loan application not only increases your chances of approval but can also help you get more favorable terms.
Here’s how to prepare your business before entering the loan process:
Clarify the Purpose
Be specific about what the loan will fund – whether it’s for equipment, expansion, or another strategic investment.
Review Your Credit History
Check both your personal and business credit reports for errors that could affect your loan terms or approval odds. Typically, to qualify for a standard bank-issued business term loan, a personal credit score above 680 is preferred.
Gather Financial Statements
Compile up-to-date balance sheets, income statements, cash flow statements, and tax returns to demonstrate financial health.
Develop a Business Plan
Draft or update your business plan to show how the loan will contribute to your business growth. Be sure to include realistic financial projections.
Assess Your Debt Service Coverage Ratio (DSCR)
Understand this key financial metric that lenders use to evaluate your ability to repay the loan. The Debt Service Coverage Ratio (DSCR), also known as the Debt Coverage Ratio, is a financial ratio used by lenders to assess a business’s ability to repay a term loan. It measures the cash flow available to service a company’s current debt obligations, including principal, interest, lease payments, and other types of debt service.
A DSCR of 1 means your business’s net operating income is equal to its debt payments. Values above 1 indicate that the business has more income than necessary to cover its debt obligations, while a DSCR below 1 implies insufficient cash flow.
Most traditional lenders look for a minimum DSCR of 1.2 to 1.25 and SBA-backed loans may allow a DSCR as low as 1.15.
Prepare for a Personal Guarantee
If necessary, be ready to back your loan personally, especially if your business does not have an established credit history or significant assets.
Outline Your Repayment Plan
Clearly detail how you plan to tackle repayments within your budget without jeopardizing other critical business operations.
Research Potential Lenders
Compare rates, terms, fees, and application requirements from multiple lenders to find the best fit for your business needs.
Legal and Tax Consultation
Consider speaking with legal and tax experts to understand the implications of taking on additional debt.
Financing Alternatives for Small Businesses
When a term loan doesn’t quite align with the needs or circumstances of your business, several other financing options exist, each with its unique characteristics:
Business Line of Credit
A revolving line of credit functions similarly to a credit card, with your business having access to a certain amount of funds to use as needed.
Unlike term loans with their fixed repayment schedule, lines of credit offer flexibility in borrowing and repaying funds. Interest is only paid on the amount used rather than the full loan amount, potentially making this a good option for ongoing liquidity needs rather than long-term investments.
Equipment Financing
This form of financing is for purchasing new equipment where the equipment itself often serves as collateral for the loan.
Equipment financing is more specific than general-purpose term loans and can be easier to qualify for since the equipment secures the loan. It’s designed strictly for asset acquisition, whereas term loans can fund a broader range of business needs.
Invoice Factoring
Invoice factoring involves selling your accounts receivable to a third party at a discount in exchange for immediate cash.
The cash flow provided by invoice factoring is not a loan but an advance on your invoices, so it doesn’t incur debt. However, it can be more expensive in the long run than a low-interest term loan and is suited for immediate cash flow needs rather than capital investment.
The Verdict on Business Term Loans
Navigating through business financing options can be overwhelming, but learning how business term loans work is important for making the right choice. Term loans can be useful for fueling growth, buying equipment, or providing working capital, yet it’s essential to evaluate whether they align with your business’s needs and goals.
Understanding the costs and repayment expectations are essential parts of choosing between a term loan or an alternate funding source. For most, it boils down to how much money you need, how steady your cash flow is, how soon you need funds, and how these factors balance out against the total cost of borrowing.
Your decision-making should always tie back to your broader business strategy. The key is to ensure that any borrowed money works for your business and doesn’t put unnecessary strain on its future.
