A business term loan is money that a company borrows in exchange for specific lending terms from the lender. Businesses (large and small) mostly use term loans to purchase fixed assets like property, real estate, machinery and equipment. However, you can use the proceeds of a business term loan for pretty much anything, from working capital to marketing, expanding your product line, and everything in-between.
The biggest selling point for business term loans is that they offer lower interest rates compared to most other financing options. Plus, they are generally more flexible. Nonetheless, no two business term loan products are alike. What works for one company might not work for your business.
For instance, a term loan that’s ideal for marketing might not be good for opening a new branch. That’s why we’ve broken down everything you need to know about business term loans to help you figure out how to choose the best one for your business.
Term loan definition
Before we dive into the details of term loans, let’s start with the basics: What is a term loan? A term loan is a credit facility that provides your business with a lump sum of money up front in exchange for lending terms. You can apply for a term loan from a bank, credit union or online lenders. Either way, these credit facilities are great for financing one-off investments for your business.
You may have noticed that the definition of a term loan mentions that borrowers get a lump sum of money in exchange for lending terms. These terms include a full commitment to pay back the full amount, typically at fixed intervals, with interest and over a pre-specified period of time. Depending on your company’s financial health and credit history, you may need to make a down payment to lower the lender’s risk while at the same time reducing your payment amounts and total cost of credit.
Tip: want to get favorable lending terms for a term loan? Start by building your business credit. Here’s how to do it.
Every business term loan carries an interest rate, which can either be fixed or variable. While a fixed rate remains the same for the entire term of the loan, a variable rate changes over time. Business term loans also have a repayment schedule which is often monthly but can be quarterly. Contrary to other types of loans, you generally won’t be penalized for paying off a business term loan ahead of schedule.
Business term loans are either secured or unsecured. If you opt for a secured loan, then you’ll need to offer a personal guarantee or collateral to the lender. Should you fail to repay the loan, your lender can legally seize whatever asset you put up as collateral – whether it’s a business asset, your personal home, or your car.
An unsecured term loan doesn’t require any collateral or personal guarantee, which makes it riskier to the lender. As a result, providers typically charge higher costs, higher interest rates and offer shorter repayment periods. While unsecured business term loans may be appealing, they can put a major strain on your cash flow because of their shorter repayment period.
Also, worth noting is that every business term loan comes with fees. These vary from lender to lender but may include origination fees, monthly fees, annual fees, late payment fees, and (in very rare cases) prepayment fees. Before committing to a term loan, you’ll want to talk to your lender and tot up all these fees to see how much they affect the total cost of the loan and your monthly payments. It will also give you an idea of whether your cash flow is enough to pay the loan with its associated fees.
Why use term loans for your small business?
There are several reasons why business owners prefer term loans over most other financing options:
Lump sum of money: with a business term loan, you get a lump sum of cash that you can use to finance high-cost business needs.
Low interest rates: business term loans have long durations, which often allows lenders to offer lower interest rates compared to short-term loans.
Predictable repayment schedule: the set payment structure of a business term loan is typically monthly or quarterly. This predictability makes planning for payments easier, thus giving you some peace of mind.
Good for cash flow: a business term loan helps you acquire assets that would have otherwise put a strain on your cash flow if you had opted to make the same purchase with business profits.
Improves business credit score: as a form of credit, a term loan boosts your business credit score when you make timely payments.
Tax deductions: the interest charged on a business term loan is deductible, which saves you some cash when tax season rolls around.
A great example of a business term loan is the SBA 7(a) loan. Designed for long-term financing, the maturity of the SBA 7(a) depends on the purpose of the loan, the borrower’s ability to repay, and the useful life of the asset being financed. You can get a 25-year term if you use the loan for real estate and up to 10 years if you use it for working capital.
Repayment of the SBA 7(a) includes a monthly principal as well as interest payments. If the lender gives your business a fixed interest rate, it means that your monthly payments will remain the same for the entire term of the loan. On the other hand, a variable interest rate means that your rate will fluctuate, causing loan payments to vary each month.
If your business is a startup or embarking on an expansion, the lender may give you an interest-only SBA 7(a) loan. In this case, you’ll only pay the interest on the loan for the first few years and skip principal payments. This allows your business to generate income, which you can then use to pay back the loan in full. That said, SBA loans – including the 7(a) – typically don’t allow balloon payments.
If the maturity of your SBA 7(a) loan is shorter than 15 years, then you can prepay it in full without any prepayment penalties. However, if the maturity is 15 years or longer, the SBA will charge you a prepayment fee. You’ll also need to provide business and personal assets as collateral for the loan.
Types of term loans
There are three main types of term loans: short-term loans, intermediate-term loans and long-term loans.
Short-term loans: these are business term loans that have a typical repayment period of one year or less. They make great alternatives to lines of credit, particularly for businesses that have credit challenges. The downside of short-term business loans is that they often carry high interest rates, which makes them costlier. Plus, you may need to make daily loan payments to avoid falling behind.
Intermediate-term loans: also known as mid-term loans, intermediate-term loans generally run between one and five years. Payments are either bi-weekly or monthly. The biggest advantage of intermediate-term loans is that they offer a decent lump sum amount that you can use for business activities like expanding your team, opening a new location, purchasing inventory, and acquiring assets.
Long-term loans: long-term business loans run for six to 25 years. They also carry very low interest rates, making them some of the most affordable sources of business financing. However, they are very hard to qualify for because of the risk they pose to lenders. Most lenders only extend long-term business loans to companies that have established good credit, enough cash flow and sufficient assets.
TLA vs TLB
Another way of classifying business term loans is based on their amortization schedule. A term loan can either be term loan A (TLA) or term loan B (TLB). The biggest difference between TLA and TLB is that while TLA is amortized evenly over a period of 5 to 7 years, TLB is amortized nominally in the first 5 to 8 years followed by a balloon payment in the last year of the loan.
Because of the longer repayment period, TLBs are usually more expensive compared to TLAs. They also pose a bigger risk to the lender, which increases the likelihood of a higher interest rate. The balloon payment at the end can also stretch your business cash flow, particularly if the loan didn’t yield a decent ROI that you can use to make the bullet payment.
What can you use a term loan for?
You can use the proceeds of a business term loan for:
Acquiring real estate like business premises
Purchasing fixed assets like equipment
Expanding the business, e.g., opening a new location
Refinancing a business debt
Attracting and hiring new employees
Certain situations make it ideal to apply for a business term loan. For example, it makes a lot of sense to approach a lender when you need to make a costly purchase that has an obvious return on investment. Whether it’s opening a new branch for the business or bringing in a marketing team, make sure the investment will repay itself in the long run.
You’ll also want to ensure that your cash flow can meet the repayment schedule of the loan you’re applying for. The last thing you want is to take out a loan that will overstretch your cash flow, forcing the business to tank.
If you only need cash to cover ongoing operation expenses, it would make more sense to consider a revolving credit like a credit card or a line of credit. These two are known as revolver loans.
What is the difference between a revolver loan and a term loan?
A revolver loan or revolving loan is a type of credit facility that lenders extend to borrowers with the ability to withdraw or draw down, repay in full or part, and then withdraw again. A credit card and line of credit are excellent examples of revolver loans.
Basically, the lender gives you a loan limit that you can draw from whenever your business needs cash. You can’t exceed that limit. Most lenders will require you to make a minimum payment each month. This payment can be equal to or lower than the amount owed. Whatever the case, any payment you make goes into your account and you can borrow it again.
On the other hand, a term loan provides a lump sum of money that you have to pay over a fixed payment schedule. It doesn’t give you the option to reborrow whatever you’ve paid.
The repayment and reborrowing cycle of a revolver loan makes it more flexible than a term loan. When it comes to a revolver loan, you only pay interest on the amount you’ve used. That’s a contrast to a term loan where you pay interest whether you’ve used the funds or not.
Pro tip: a business line of credit is more suitable when you frequently need monetary injection to boost your cash flow. A business credit card, on the other hand, is ideal for making business purchases on credit. Click here to find out the differences and similarities of these two revolver loans and how you can use them to grow your business.
How much can your business afford?
The amount of term loan that your business can afford depends on your debt service coverage ratio (DSCR). Commonly used by lenders before advancing term loans, this ratio shows whether or not your business is in a position to repay the debt that comes with a term loan.
DSCR compares the amount of money that a business has available to service the debt that the business is taking on. The formula for calculating DSCR is:
DSCR = net operating income / debt service
Debt service includes payments for the principal and interest of the loan.
Say, for example, that your business has a net operating income of $210,000 and a total debt service of $150,000. Your DSCR would be 1.4 (calculated as 210,000 / 150,000).
If your DSCR is below 1, it means that your business doesn’t have the ability to fully repay its debts. Say, for example, that you have a DSCR of 0.9; that means you’re only able to pay 90% of your debts. It also means that you probably shouldn’t be taking up more debts. In fact, most lenders won’t extend any credit to your business.
A DSCR of 1 means that you’re able to pay 100% of your financial debts. While this may seem sustainable, it really isn’t. A slight variation in your business cash flow will leave you vulnerable.
If the DSCR is above 1, it means that your business makes enough money to pay its debts and still remain with more money. This is ideally what you should be aiming for – a debt service coverage ratio that’s above 1. The proportion that’s beyond the 1 represents the amount of debt that you can comfortably take up.
In the example above, the imaginary business makes $210,000 in net operating income and has a debt service coverage ratio of 1.4. That means $150,000 goes to servicing debts and the business is left with $60,000 in its cash flow that it can use to take up more debt. This is how to objectively determine how much loan your business can take up – using the DSCR. This ratio will give you a clear idea of how much of your cash flow you can dedicate to taking out new term loans.
Here’s a free term loan calculator that can help you figure out how much loan your business can afford.
How do you apply for a term loan?
The process of applying for a business term loan is the same as applying for any other business loan. Start by approaching a lender of your preference and evaluate the terms of their loan products. They’ll require you to provide financial statements that demonstrate your creditworthiness. These include bank statements, tax returns, the latest balance sheet, a business plan etc.
Some lenders may also ask for a business EIN alongside your social security number. If you meet the lender’s eligibility requirements, they’ll approve your term loan application and give you a lump sum of cash. Needless to say, you’ll be required to make payments over the period of the loan, typically on a monthly or quarterly payment schedule.