What is a Term Loan and How Can You Secure One?
This post will explain what term loans are and how they can be used by business owners. After reading this post, you’ll fully understand how term loans work and how they can help you achieve your business goals.
Term Loan Definition:
Businesses require working capital to buy the assets needed to produce their goods and services. The working 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 typically has set payments (usually monthly) and a maturity date when the loan must be repaid. The full loan term is usually for more than one year. Term loans are often used to pay for fixed assets, but some businesses may use it for day-to-day operations.
Usually, term financing comes in the form of a bank loan, which can cause some delays in the funding process. Most bankers will evaluate your credit and your sales history, as they want to work with established businesses with good credit.
Next, 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.
When interest rates are high, a variable rate may be worthwhile, 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. 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 deciding 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 buy 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 must spend significant money on maintaining an older vehicle, you’ll benefit less from the loan.
The Pros and Cons of Term Loans for Business Owners
Every financing option has advantages and disadvantages, and term loans are no exception. Once you understand the pros and cons of term loans, you’ll feel more confident in pursuing this funding option.
Advantages of Term Loans
- Potential for Additional Income: 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.
- Low Monthly Down Payments: Receiving a term loan with low monthly payments will help you buy more assets without exhausting your cash flow.
- Less Strict Credit Requirements: You don’t need excellent personal or business credit to qualify. 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.
- Added Cash Flow: A term loan can help grow a business when suppliers of fixed assets aren’t willing to extend credit. Due to this, your business won’t have to wait for cash reserves to fund the purchases of assets.
- Potential for Increased Returns: When used correctly, this type of leverage can boost your company’s returns. By buying assets that produce economic value, the leverage factor can help you buy more.
- Ability to Maintain Ownership: Businesses can secure a significant amount of capital without losing equity. Conversely, venture capital companies that fund large sums will require a part of the equity in a company. Losing equity means losing some control over your business.
Disadvantages of Term Loans
- Hard to Qualify For: Since banks are the dominant provider of term loans, they are also the most difficult to obtain.
- Collateral Often Required: Banks may require collateral and personal guarantees in order to provide term loans to business owners. Due to this, there won’t be any protection against bankers going after personal assets.
- Variable Rates: Bankers may not be willing to lend at fixed interest rates. Variable rates can cause payments to be out of reach for business owners. However, businesses can negotiate caps in the rate.
- Potential for Loss: If the assets bought from the loan amount 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.
- Potential Prepayment Penalties: 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. This will increase the total cost of the loan, even though you paid it off earlier than needed.
How to Obtain a Term Loan
As mentioned, banks aren’t usually open 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 annual 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.
However, pursuing a bank loan isn’t your only option. The Small Business Administration (SBA) provides SBA loans to business owners who can’t secure traditional financing. In addition, alternative lenders also provide small business loans, and usually offer a faster, more lenient funding process.
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Conclusion: Consider Term Loans for Your Small Business
Hopefully, this article has helped you understand term loans. Obtaining term loans can be a good option for expanding your business, especially if you’re pursuing growth opportunities.
Before you start the application process, take time to consider the following:
- What are your financing needs? You should know how you’ll use business financing to improve your business.
- Are you able to responsibly repay the loan? Before taking out a loan, you should be confident in your ability to pay off your loan on time.
- Have you researched other types of funding? Although term loans are a practical funding option, be sure to weigh your options. For example, some business owners pursue business lines of credit, credit cards, or merchant cash advances. These options are different than term loans, so it’s important to do thorough research.
Editor’s Note: This post was updated for accuracy and comprehensiveness in November 2021.
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.