What Are Term Loans and How Do They Work? A Detailed Overview

Term loans are a common type of business financing used by companies to obtain a lump sum of cash upfront. In exchange, the borrower agrees to repay the loan over a set period of time, known as the loan term, along with interest. Term loans can be an effective way for businesses to fund large purchases expansions or other growth needs when they require capital quickly. But how exactly do term loans work and what should you know before applying for one? This comprehensive guide provides an in-depth look at everything related to term loans.

What Is a Term Loan?

A term loan is essentially a contract between a lender and a borrower in which the lender provides a lump sum payment upfront and the borrower repays the loan over a set period of time through fixed installments. The loan term, interest rate, and repayment schedule are all established upfront in the loan agreement.

Term loans are a type of installment loan meaning the total loan amount is paid back little by little through multiple scheduled payments, rather than all at once. This spreads out the impact for the borrower rather than having to repay everything in a single large payment.

Term loans are commonly used to finance large business expenses like:

• Purchasing equipment
• Buying, expanding, or renovating facilities
• Funding a new product line or service offering
• Expanding operations and hiring more staff
• Settling tax obligations
• Consolidating higher interest debt
• Covering operating expenses and short-term cash flow needs

While term loans require repayment over time, they provide businesses with immediate access to capital that can be used to fund investments and growth.

How Do Term Loans Work?

When a business needs a term loan, they will apply through a lender such as a bank, credit union, or online lender. The lender will evaluate the business’ finances, credit, and ability to repay the loan.

If approved, the lender will extend a term loan offer detailing:

• Loan amount
• Interest rate
• Loan term length
• Payment amounts & frequency (monthly, quarterly, etc)
• Collateral requirements
• Fees

Interest Rates

Term loans typically have fixed or variable interest rates.

• Fixed rate loans maintain the same interest rate over the full loan term. This provides predictable payments but less flexibility if rates fall.

• Variable rate loans fluctuate based on market indexes like the prime rate. Rates start lower but payment amounts can go up or down over time.

Loan Term Length

Term loans are categorized by their repayment term lengths:

• Short-term: Under 1 year
• Intermediate-term: 1-3 years
• Long-term: 3-10 years or longer

Longer terms mean lower monthly payments but higher overall interest costs over time. Shorter terms provide faster access to equity but require higher payments.

Collateral

Term loans may be secured or unsecured:

• Secured loans require collateral like business assets to secure the loan in case of default. This provides the lender with an asset to liquidate and offsets some of their risk.

• Unsecured loans don’t require collateral. They are riskier for lenders so interest rates tend to be higher.

If the borrower accepts the term loan offer, funds are distributed upfront in a lump sum payment. The borrower then repays the loan in monthly or quarterly installments over the loan term.

Types of Term Loans

There are several different types of term loans available:

Bank Term Loans

Banks and credit unions provide term loans directly to qualifying businesses. They tend to offer lower interest rates but have stricter approval criteria. Bank term loans generally range from 3-10+ years.

SBA Loans

The U.S. Small Business Administration guarantees certain loans made by lenders to qualifying small businesses. SBA term loans provide appealing low fixed rates and long terms of 10-25 years. But they have an extensive approval process.

Online Term Loans

Online lenders like LendingClub and Fundbox provide short-term loans of 1 year or less. Their application process is faster than banks but interest rates are higher.

Lines of Credit

Lines of credit aren’t technically term loans but can function similarly. With a business line of credit, funds don’t need to be borrowed all at once. The business can draw amounts as needed up to a set limit.

Invoice Financing

Invoice financing lets businesses borrow against unpaid customer invoices to obtain working capital. Once invoices are paid, the loan is repaid. No fixed monthly payments are required.

Equipment Financing

Equipment financing lenders provide loans specifically for purchasing equipment. Payments are structured around the expected lifespan of the equipment.

Pros and Cons of Term Loans

Advantages

• Receive large lump sums for immediate financing needs
• Lock in fixed interest rates
• Spread repayment over time
• Potentially lower rates than credit cards or lines of credit
• Improve business credit with on-time payments

Disadvantages

• Lengthy application and approval process
• Inflexible payment structure
• Higher costs over the full loan term
• Collateral may be required
• Prepayment penalties may apply

Overall, term loans allow businesses to access capital for growth when other options won’t suffice. But the loan agreement should be carefully evaluated to ensure the terms fit the business’ needs and repayment ability.

What Do You Need to Qualify for a Term Loan?

Lenders have specific criteria borrowers must meet to be approved for a term loan:

• Time in business: Most require at least 1 year of operations.

• Revenue/Cash flow: Enough steady income must be generated to make loan payments comfortably. Minimum annual revenue levels apply.

• Credit score: A minimum personal/business credit score is required, typically around 580-650+

• Debt-to-income: Existing debts shouldn’t exceed a certain percentage of revenue.

• Collateral: For secured loans, sufficient business assets must be pledged.

Meeting the lender’s qualification standards is key for approval and securing better loan terms. A higher credit score, lower debt burden, and strong cash flow will result in better offers.

What Are the Steps to Getting a Term Loan?

Applying for a term loan involves several key steps:

1. Determine the loan amount needed – Consider costs to finance and required down payments. Get preapprovals before spending money.

2. Check eligibility requirements – Ensure your time in business, credit score, revenue, and existing debt allow you to qualify.

3. Compare lender options – Research different banks, credit unions, SBA lenders, and online lenders. Compare interest rates, loan terms, and fees.

4. Submit the application – Provide documents proving business financials, credit scores, collateral ownership, and ability to repay.

5. Accept the loan terms – If approved, evaluate the lender’s term sheet thoroughly before signing to ensure the loan works for your needs.

6. Satisfy any pre-closing contingencies – Some lenders may require appraisals, inspections, insurance coverage, or other items before finalizing.

7. Close the loan – Review final closing documents, sign the loan agreement, and obtain the lump sum of funds.

Make sure to evaluate multiple lenders and get pre-approvals before spending any money to find your best option. The lender can guide you through the process once you apply.

What Happens if You Default on a Term Loan?

Defaulting on a term loan occurs when loan payments are late or missed altogether. Default can result in:

• Late fees and penalties

• Higher default interest rates

• Credit damage – Lenders report defaulted loans to credit bureaus

• Lawsuits – The lender can sue for repayment of the loan balance

• Wage garnishment – Lenders may garnish wages to recover amounts owed

• Collateral liquidation – For secured loans, the lender may seize and sell pledged collateral

• Bankruptcy – Inability to repay debts could force the business to declare bankruptcy

To avoid default, it’s critical to only borrow what your business can realistically afford to repay based on predictable cash flow. Cutting expenses or finding ways to increase income can help remedy potential repayment issues.

Options for Early Repayment of a Term Loan

While term loans require repayment over a set period, some options allow for early repayment:

• Prepayments – Making extra payments toward principal is usually allowed to pay off the balance early.

• Refinancing – The loan can be refinanced with a new lender at lower interest rates or better terms.

• Shorter term – Choose a shorter initial repayment term to build equity faster.

• Home equity loan – Business owners can potentially tap home equity to repay the term loan.

• Business profits – Excess profits not relied on for income can be applied toward early repayment.

However, prepayment penalties or fees may apply if outlined in the original loan agreement, especially