Business Loan Terms: How to Pick the Right Financing Term
While loan terms are very important, you can’t decide on the ideal term until you’ve first answered these questions.
For example, let’s say you need $1,000,000 to finance the construction of a small apartment complex that you plan to sell. Ideally, the life of the loan should end around the time you realize revenue from the sale of the building. That way, you can pay off your business loan with your sales proceeds and stop paying interest.
Of course, construction loans are designed for a specific purpose. Business loans, on the other hand, can fund anything from inventory and marketing to mergers and acquisitions. Therefore, for traditional business loans, the ideal term varies considerably.
To help you pick the ideal term for your business loan, this post will explain how business loan terms work. Then, we’ll summarize the situations in which certain terms work best.
How Do Business Loan Terms Work?
A business loan’s term is the period from the date the loan closes (the Closing Date) and the date that the loan is terminated or repaid.
For example, when you get a mortgage on your home, your loan traditionally has a 30-year term. This means your payments are spread out over 30 years, making it a long term personal loan. Business loan terms usually aren’t 30 years, but the idea is the same.
Keep in mind that you may also hear a business loan’s term called the “loan repayment period” or the “borrowing period.” Regardless of what it is referred to, when you’re speaking about loan terms, you’re referring to the length of the repayment period.
What Is The Difference Between Short, Medium, and Long-Term Business Loans?
If you’re a small business owner researching additional financing, you’ve probably seen them referred to as short-term, medium-term or long-term. What’s less clear is exactly what that means, and how to select a term that fits your business’s financial needs.
Below, you’ll find an easy reference chart for the typical lengths of business loan terms.
|Short||One year or less||Line of credit, bridge loans, microloans|
|Medium||One to five years||Student loans, equipment financing|
|Long||More than five years||Traditional business loan, mortgages, SBA 7(a) loan|
What to Consider When Choosing a Business Loan Term:
As mentioned earlier, choosing a small business loan term starts with determining what you’ll use the loan for. Beyond that though, you’ll want to consider two other important factors:
- Potential interest costs
- Cash flow
To consider interest costs, you’ll need to understand how different loan terms affect interest expense. Once we thoroughly explain this, we’ll detail how cash flow plays a part in this.
1. Interest Costs and Your Loan Term
Most of the cost you pay for a loan comes from interest payments. Since you pay interest over time, though, the term of your loan affects how much interest you pay.
For example, compare a $100,000 loan with a borrowing period of one year versus the same loan with a borrowing period of ten years.
Assuming these loans both have an interest rate of 10 percent, your interest expense for the 10-year loan would be $58,580.88. For the 1-year loan, your interest expense would be $5499.06.
While this is an oversimplified example, it illustrates how interest costs vary based on your loan term. Assuming all else is equal, you’ll pay more interest expense on a loan with a longer term versus a shorter term. Keep this effect in mind when you’re evaluating potential loan terms.
2. Matching Cash Flow to Your Loan Term
Maintaining healthy cash flow is a key challenge for any small business. To that end, you must choose a loan term that aligns with your cash flow needs.
With shorter loan terms, you’ll need to pay back your loan faster so your payments will be relatively large. With longer-term loans, you may have smaller payments, but they’ll extend over longer durations.
In either case, you need to make sure your payment dates and amounts line up favorably with other cash inflows and outflows. Otherwise, you can easily end up with no cash on hand to make your payments.
3. Consider Your Credit Score
Anytime you borrow money, your loan offer will likely be contingent on your credit score. Although it is possible to get a bad credit business loan, you may not be given an ideal loan term.
If this occurs, it might be best to work on improving your credit score prior to applying for a small business loan. In some cases, this might you to consolidate debt, pay bills in-full and on-time, or approve other aspects of your business’s finances.
Conclusion: A Final Note on Picking the Right Loan Term
Finding the right term for your loan is a balancing act. If you choose a term that is too long, you’ll pay more than you need to in interest payments. However, if you choose a term that’s too short and while your interest expense may be lower, your payments could be unmanageable.
On top of all that, long-term loan options typically allow for larger loan amounts. Due to this, if you need a large influx of cash, your decision may already be made for you.
To simplify things and find your ideal term, we’d recommend going back to the two questions we started this post with:
- How much additional working capital does your business require?
- What do you need the money for (equipment, real estate, inventory, etc.)?
Answer these questions, narrow down your list of business financing options, then compare the terms offered by those options. After that, it’ll be much easier to determine your ideal loan term.
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.