What is a term loan?
A term loan offers borrowers a lump sum of cash in exchange for specific borrowing terms. Term loans are normally intended for small established businesses with strong financial statements. In exchange for a certain amount of cash, the borrower agrees to a certain repayment schedule with a fixed or variable interest rate. Term loans may require large down payments to reduce payment amounts and the total cost of the loan.
Key points to remember
- A term loan offers borrowers a lump sum of cash in exchange for specific borrowing terms.
- Borrowers agree to pay their lenders a fixed amount over a certain repayment schedule with a fixed or variable interest rate.
- Term loans are commonly used by small businesses to purchase fixed assets, such as equipment or a new building.
- Borrowers prefer term loans because they offer more flexibility and lower interest rates.
- Short and medium term loans may require lump sum payments while long term facilities come with fixed payments.
Understanding Term Loans
Term loans are usually given to small businesses that need money to buy equipment, a new building for their production processes, or any other fixed asset to keep their business going. Some businesses borrow the cash they need to operate on a monthly basis. Many banks have set up term loan programs specifically to help businesses in this way.
Business owners apply for term loans the same way they would any other credit facility, by contacting their lender. They must provide statements and other financial evidence demonstrating their solvency. Approved borrowers receive a lump sum in cash and are required to make payments over a certain period of time, usually on a monthly or quarterly repayment schedule.
Term loans have a fixed or variable interest rate and a fixed term. If the proceeds are used to finance the purchase of an asset, the useful life of that asset can affect the repayment schedule. The loan requires collateral and a rigorous approval process to reduce the risk of default or default. As noted above, some lenders may require down payments before advancing the loan.
Borrowers often choose term loans for several reasons, including:
- Simple application process
- Receive a lump sum in advance in cash
- Specified payments
- Lower interest rates
Taking out a term loan also frees up money from a company’s cash flow for use elsewhere.
Types of term loans
Term loans come in many forms, usually reflecting the life of the loan. These include:
- Short-term loan: These types of term loans are generally available to businesses that do not qualify for a line of credit. They usually last less than a year, but they can also refer to a loan of up to 18 months.
- Medium term loans: These loans typically last between one and three years and are paid in monthly installments from the cash flow of the business.
- Long term loans: These loans last between three and 25 years. They use company assets as collateral and require monthly or quarterly payments from profits or cash flow. They limit other financial commitments the business can make, including other debts, dividends, or principal salaries, and may require an amount of profit set aside specifically for loan repayment.
Short and medium term loans can also be lump sum loans with lump sum payments. This means that the last installment swells or swells by a much larger amount than the previous ones.
While the principal of a term loan is technically not due until maturity, most term loans operate on a specified schedule requiring a specific payment amount at certain intervals.
Example of term loan
A Small Business Administration (SBA) loan, officially known as a 7 (a) secured loan, encourages long-term financing. Short-term loans and revolving lines of credit are also available to meet the immediate and cyclical working capital needs of a business.
The maturities of long-term loans vary depending on the repayment capacity, the purpose of the loan and the useful life of the financed asset. Maximum maturities are generally 25 years for real estate, up to ten years for working capital and ten years for most other loans. The borrower repays the loan with monthly payments of principal and interest.
As with any loan, an SBA fixed rate loan payment remains the same because the interest rate is constant. Conversely, the repayment amount of a variable rate loan can vary since the interest rate fluctuates. A lender can establish an SBA loan with interest payments only during the start-up or expansion phase of a business. As a result, the business has time to generate income before paying off the loan in full. Most SBA loans do not allow lump sum payments.
The SBA charges the borrower a prepayment fee only if the loan has a maturity of 15 years or more. Business and personal assets secure each loan until the salvage value equals the loan amount or until the borrower has pledged all assets as reasonably available.
Why Do Businesses Get Term Loans?
A term loan is usually for equipment, real estate, or working capital that is repaid between one and 25 years. A small business often uses the money from a term loan to purchase capital assets, such as equipment or a new building for its production process. Some businesses borrow the money they need to run from month to month. Many banks have set up term loan programs specifically to help businesses in this way.
What are the types of term loans?
Term loans come in many forms, usually reflecting the life of the loan. A short-term loan, typically offered to businesses that don’t qualify for a line of credit, typically lasts for less than a year, although it could also refer to a loan of up to about 18 months. A medium-term loan typically lasts more than one to three years and is paid in monthly installments from the company’s cash flow. A long-term loan has a term of three to 25 years, uses business assets as collateral, and requires monthly or quarterly payments from earnings or cash flow.
What are the common characteristics of term loans?
Term loans have a fixed or variable interest rate, a monthly or quarterly repayment schedule, and a fixed maturity date. If the loan is used to finance an asset purchase, the useful life of that asset can affect the repayment schedule. The loan requires collateral and a rigorous approval process to reduce the risk of default or default. However, term loans usually carry no penalty if they are repaid earlier than expected.