What is a Term Loan? Explaining The Term Loan Process
As you probably know, assets are the lifeblood of a business, and the right ones can produce significant revenues. With leverage, businesses can extend those revenues. Then, the business can buy more assets with the same equity base. If you’re in this situation, term loans can be a good solution.
This post will detail what term loans are and how they may be used to help your business. After reading this post, you’ll fully understand term loans and how they can help you achieve your business goals.
What is a Business Term Loan?
Businesses require capital to purchase the assets needed to produce their goods and services. The capital requirements for businesses are often larger than the amount of cash available to the business. A term loan can help fund these capital requirements.
A term loan is for set payments (usually monthly) and a maturity date when the loan is to be paid back. The full loan term is usually for more than one year. Term loans are often used to pay for fixed assets for the business, but some businesses may use it for day-to-day operations.
The most common lender for a term loan is a bank, which can cause some delays in the funding process. Most bankers that you work with will evaluate your credit and your sales history. They want established businesses with good credit.
You’ll negotiate whether the interest rate charged on the loan will be fixed or a variable rate. Usually, fixed interest works well when the prevailing interest rates are low, and a bank will lend to you at a low rate. When interest rates are high, a variable rate may be a better choice, as you can negotiate the rate below the current interest rate. Ask your lender if you can have a rate cap implemented to keep the payment affordable.
How Do Small Business Term Loans Work?
When you seek out a term loan, the lender agrees to give you a lump sum of cash in exchange for future payments. These payments are usually monthly, but you can work out other arrangements. Most likely, you’ll agree on the interest rate, the maturity date, and whether there are any reset rate provisions.
Many business owners use this type of loan to fund the purchase of fixed assets such as equipment or other assets. When determining how long to structure a term loan, always factor in the life of the asset. If assets depreciate quickly, and you still owe money on the loan, it may cause problems in paying back the loan later in the term.
For example, let’s say you use a term loan to purchase a used vehicle to deliver products. If the loan term is for eight years and the car only lasts six, you’ll be paying off a loan for something that no longer produces economic value. This concept is known as being upside down.
The solution to this problem is to pursue a short term loan or choose longer lasting assets. Luckily, assets such as cars are likely to last longer than six years. However, if you have to spend significant money on maintaining an older vehicle, you’ll get less benefits from the loan.
Advantages and Potential Disadvantages of Term Loans
Every financing option has advantages and disadvantages, and term loans are no exception. When you learn about the pros and cons of term loans, you’ll feel more confident in pursuing this option.
Term loans aren’t right for every business situation. That’s why it pays to learn about the conditions on when to use them.
Advantages of Term Loans
- Term loans can provide funding for needed fixed assets or equipment. These assets can generate income, which will be put towards paying off the loan.
- The loan can be structured with low monthly payments. This helps you buy more assets without exhausting your cash flow.
- You don’t need excellent personal or business credit to qualify. Generally, a credit score of around 650 should be enough to qualify for a term loan. However, higher credit scores will attract better loan rates and terms.
- A term loan can help grow a business when suppliers of fixed assets aren’t willing to extend credit. Your business won’t have to wait for cash reserves to fund the purchases of assets.
- When used correctly, this type of leverage can boost returns for your company. By purchasing assets that produce economic value for the firm, the leverage factor can help you buy more.
- Businesses can secure a significant amount of capital without losing equity. Conversely, venture capital companies that fund large sums will require a portion of the equity in a company. Losing equity means losing some control over your business.
Potential Disadvantages of Term Loans
- Since banks are the dominant provider of term loans, they are also the most difficult to obtain.
- The loan amounts you can borrow are often significant. If the business suffers a downturn, the collateral committed may be forfeited to the bank.
- For small business owners, banks may require collateral and personal guarantees. Due to this, there won’t be any protection against bankers going after personal assets.
- Bankers may not be willing to lend at fixed interest rates. Variable rates can cause payments to be out of reach for small business owners. However, businesses can negotiate caps in the rate.
- If the assets purchased with the financing don’t produce value, and there are several months left on the term loan, the business owner may be upside down. This means that the business is paying money for no value.
- Some term loans are structured with prepay penalties. If you want to pay off the loan before its maturity date, you might pay hefty fees.
- Interest-only loans that are compounded could spiral the payment. Essentially, this means interest is tacked onto the principal.
Where Can I Obtain A Term Loan?
As mentioned, banks aren’t usually amenable to funding small businesses. They’ll require both a business and personal credit check. In addition, they usually prefer established businesses that have been operational for two years or more.
Before applying, you’ll need to find out the bank’s revenue requirements. When speaking to a banker, be sure to understand everything on the term sheet before signing. You’ll also need to know whether the rate is fixed or variable, and if the loan is secured or unsecured. Usually, for long-term loans, bankers won’t fund unstructured loans due to the risk.
If you want to learn more about how business loans work, check out our Small Business Loans Guide. At Fora Financial, we help small business owners learn everything they need to know to succeed in their business.
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Alternatives to Term Loans for Small Businesses
At Fora Financial, we provide small business loans up to $500,000. We usually have faster approval times than banks and with more lenient terms. If approved, you may receive your funds in as little as 72 hours.
Hopefully, this article has helped you understand term loans. Obtaining term loans can be a good option for expanding your business, as you can buy more assets that produce value for your firm.
If you want to learn more about business loan options, get a free quote from one of our loan experts today.
Frequently Asked Questions
Should a business use term loans for day-to-day operations?
While some businesses choose term loans for day-to-day operations, it may not be the most efficient use of capital. There are better alternatives for this short-term funding. Term loans are usually for assets that will last as long as the loan term. A good rule-of-thumb is to structure loans for the same amount of time that you’ll need the money or for the life of the assets funded by the loans.
Are Interest Rates on Business Loans Tax Deductible?
They can be. However, every business is different, and it’s difficult to generalize about topics relating to loans and taxes. To find out, speak with your accountant or qualified tax professional.
How Are Term Loans Different Than Lines of Credit?
Lines of credit are comparable to credit card debt. With a credit card, you can spend up to your credit card limit. When you pay that off, you’ll once again have that amount available for spending. This is how a line of credit works, too.
When you take out a mortgage or an auto loan, you repay the loan in monthly installments that include some principle and interest that make up the payment. This is the way term loans work. At Fora Financial, we wrote an article describing the concept in detail.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.