Among the countless financing options available for small business owners, a business term loan is one of the best. You can use business term loans at almost any stage of your business’s growth, whether you want to build up your customer base, expand operations, or explore new projects.
Not all business term loans are alike, though. To help you figure out whether or not a term loan is right for you, we’re breaking down everything you need to know.
A term loan is a type of loan that provides a business or individual with a lump sum of cash upfront and specifies a schedule for repayment over a set period of time. Term loans are a useful source of financing for various purposes, but it’s important to understand how they work before taking one out.
What is a Term Loan?
A term loan is a loan that is repaid over a set timeframe or “term”. The term can range from a few months to several years, depending on the purpose and structure of the loan.
With a term loan, the borrower receives the full amount of the loan upfront as a lump sum payment. The loan amount, interest rate, fees, repayment schedule, and term length are all established at the beginning of the loan
The borrower then repays the loan in regular installments over the loan term until it is fully paid off These installment payments are usually made monthly, but can also be weekly, bi-weekly, quarterly, etc
A portion of each payment goes towards interest charges, while the remainder reduces the principal balance. Many term loans have equal installment payments, meaning each payment is the same over the life of the loan.
Term loans can be secured or unsecured. Secured loans require collateral like real estate, equipment, or investments to guarantee repayment. Unsecured loans don’t require collateral.
Common Uses of Term Loans
Term loans have many uses for both businesses and consumers. Here are some of the most common uses:
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Business expansion – Buying real estate, equipment, inventory, or other assets to grow a business. The purchased asset often serves as collateral.
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Debt consolidation – Paying off higher interest debts with a new term loan at a lower rate. This reduces overall interest costs.
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Home improvements – Financing major home remodeling projects like a kitchen renovation. The home itself serves as collateral.
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Vehicles – Buying a new or used car, truck, or other vehicle where the vehicle is the collateral.
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Education – Paying for college or graduate school expenses. These are usually unsecured loans.
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Medical expenses – Covering the costs of expensive medical procedures that insurance doesn’t fully pay for.
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Life events – Paying for a wedding, adoption, family vacation, or other major life event.
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Emergencies – Accessing funds needed urgently due to a job loss, medical emergency, or other financial hardship.
Features and Benefits of Term Loans
Term loans offer several benefits that make them useful financing options:
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Fixed regular payments – Installment payments are predictable, allowing easier budgeting.
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Large lump sum – Borrowers gain access to a large amount of cash upfront.
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Set payoff date – Loans are completely paid off by a specific date.
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Potentially lower rates – Interest rates may be lower than other types of credit like credit cards.
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Ability to borrow larger amounts – Term loans provide access to more financing than other products.
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Credit building – Responsibly managing a term loan can improve your credit score over time.
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Interest savings – Can consolidate higher interest debt into a lower rate term loan.
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Tax benefits – Interest expenses on term loans may be tax deductible in some cases.
Drawbacks and Risks of Term Loans
Term loans also come with some potential downsides to be aware of:
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Debt burden – Loans must be repaid regardless of income fluctuations. This fixed obligation can create stress.
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Lengthy payoff – A loan term of 5+ years means carrying debt for an extended timeframe.
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Prepayment penalties – Paying off a loan early may incur fees.
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Late fees – Missing payments results in extra fees that add to the overall cost.
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Collateral risks – Defaulting on a secured loan risks seizure of pledged assets.
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Credit damage – Default or late payments will lower your credit score.
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Variable rates – If the interest rate adjusts, payments may rise over time.
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Qualifying difficulties – Borrowers with poor credit or limited income may not qualify.
Types of Term Loans
There are several different types and structures of term loans to meet various needs:
Mortgage Loans
Mortgage loans are secured term loans used to purchase real estate. Typical terms range from 10 to 30 years. The property serves as collateral if the borrower defaults.
Auto Loans
Auto loans finance new or used car purchases. Auto loans typically have terms of 2 to 6 years and use the vehicle as collateral.
Personal Loans
Unsecured personal loans provide lump sums for various personal uses. Terms often range from 1 to 5 years. They require a good credit score to qualify.
Student Loans
Student loans help pay for undergraduate and graduate education costs. Federal and private student loans typically have 10+ year terms.
Business Loans
Businesses use term loans to fund expenses and growth. Common business term loans include SBA loans, equipment financing loans, commercial real estate loans, and lines of credit.
Short-Term Loans
Some lenders offer term loans for shorter periods, like 6 months up to 18 months. These help bridge short-term capital needs.
Medium & Long-Term Loans
Medium-term loans have terms from 1 – 5 years. Long-term loans extend from 5 years up to 25 years for very large financing needs.
How Do Term Loan Payments Work?
Term loan payments are structured based on four primary factors:
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Principal loan amount – The upfront sum borrowed. Higher principal means higher payments.
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Interest rate – Usually expressed as a percentage charged on unpaid balances. Higher rates increase payments.
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Loan term – The number of repayment periods or length of the loan. Longer terms reduce payments.
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Amortization – The process of allocating each payment to interest and principal. Options include:
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Straight-line amortization – Equal principal payments
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Declining balance – Higher initial principal payments
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Bullet payments – Interest-only with full principal due at maturity
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Borrowers can use an online loan calculator to experiment with different loan scenarios and see the impact on monthly payments. Prepayment options can also help accelerate repayment.
How to Qualify for a Term Loan
Lenders have specific credit, income, and collateral requirements borrowers must meet to qualify for a term loan:
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Credit score – Minimum score varies by lender, usually 600 to 700 FICO. Higher scores increase eligibility.
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Debt-to-income ratio (DTI) – Monthly debt payments divided by gross income. Most lenders require max 50% DTI to qualify.
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Collateral – Pledging assets like real estate helps secure lower rates on large loans.
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Down payment – A 10-20% down payment is often required to get approved and receive better rates.
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Documentation – Tax returns, bank statements, and other verification of income and assets.
Meeting minimum requirements gets your application approved, but the highest credit scores and lowest DTIs qualify for the best rates offered.
Term Loan Interest Rates
Interest rates on term loans can be fixed, variable, or a mix of both.
Fixed rates stay the same over the full term, providing certainty but less flexibility.
Variable rates fluctuate based on market indexes like the prime rate, adding uncertainty.
Many lenders offer hybrid rates that are fixed for 3-10 years then convert to variable for the remainder of the term. This blends stability with flexibility.
Shorter term loans often have lower rates than longer term mortgages and business loans. Secured loans also tend to have lower rates than unsecured personal loans.
Finding the Best Term Loan Lender
The lender you choose for a term loan can significantly impact the rates and terms you’ll be approved for. Here are some tips for finding the best loan provider:
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Compare rates and terms from multiple competing lenders. Online lending marketplaces streamline this process.
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Look for minimal fees. Origination fees, application fees, and prepayment penalties all add to costs.
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Consider both online lenders and community banks/credit unions. Online lenders sometimes offer lower rates.
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Ask about flexible prepayment and early repayment options to avoid penalties.
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Look for lenders that report payments to credit bureaus to build your credit history.
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Review customer complaints and feedback about the lender’s servicing, application process, and customer support.
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Consider lenders that provide price match guarantees to ensure you get competitive rates.
Pros and Cons of Taking a Term Loan
Weighing the pros and cons of a term loan can help determine if it’s the right financing option:
Pros
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Large lump sum amount
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Fixed regular payments
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Set payoff date
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Lower interest rates
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Ability to borrow larger amount
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Can build credit history
Cons
Features of term loans: Other considerations
Here are a few other factors to consider when deciding on a term loan:
- Secured vs. unsecured term loans: Secured loans require you to put up collateral or provide a personal guarantee to your lender. That means that if you can’t pay back your business loan for any reason, your personal assets — like your car or house — will be on the line as payment. Unsecured loans don’t require collateral or personal guarantees, but that means they’re riskier for lenders. As a result, unsecured loans typically have higher costs and shorter repayment terms for the borrower. Short-term loans are usually unsecured, while long-term loans generally require collateral.
- Fixed vs. variable interest rates: A fixed interest rate doesn’t change once a lender sets it, but a variable rate can increase or decrease over time. Variable interest rates are tied to an index or benchmark rate, such as the prime rate. The primary benefit of choosing a fixed interest rate is predictability; there’s no guesswork when it comes to your payments. Variable rate loans, on the other hand, are more of a risk. The appeal of variable rate loans is that they tend to have a lower starting point than their fixed rate counterparts; if there’s no significant change in the prime rate, you may pay less in interest than you would if you opted for a fixed rate. However, there’s always the possibility that your payment could substantially increase if your rate increases.
Fees: Your term loan could come with a handful of different fees, including origination fees, late payment penalties, monthly or annual loan fees, and prepayment penalties (more on these later). Unless the fees are separate from your loan payments, you’ll end up paying interest on your loan and the various fees, which can mean spending more over time.
Gather your documents
Regardless of your lender, it’s helpful to have the following items on hand when applying for a term loan:
- Employer identification number (EIN): A lender uses your EIN to request your tax return transcripts directly from the IRS.
- A few years of business tax returns: Your tax returns show how you manage your finances. Lenders often require both your personal and business tax returns.
- Balance sheet and income statement: Your balance sheet and income statement paint a more complete picture of your business’s financial health, showing your expenses and profit and loss history.
- Bank statements: Your bank statements give lenders insight into how well you manage the cash coming into your business, and whether or not you’ll have the funds to pay back your loan.
- Debt schedule: A debt schedule outlines your debt obligations, including (but not limited to) loans, leases, contracts, and notes payable. This helps a lender determine whether or not you can handle taking on new debt.
- Business plan: Your business plan gives lenders a better idea of your short and long-term business goals, your business’s history and accomplishments, and the market potential for your services or products.
Statement of funding needs: In the financial section of your business plan, make sure you spell out exactly how much funding you need, what you plan to use it for, and how that investment will help grow your business. It’s crucial to be specific. Instead of saying, “I want to hire more employees,” for example, explain that you need to hire two new salespeople to bring in 10% more annual revenue.
What is a Term Loan? | DFI30 Explainer
FAQ
What is the meaning of term loan?
What does term mean with a loan?
What are the three 3 types of term loan?
What is the difference between a bank loan and a term loan?
What is a term loan?
A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and a fixed or floating interest rate.
What is the difference between a loan and a term loan?
The borrower usually has access to the full amount of principal upfront, knows when to make payments, and knows how much to pay. The lender knows that the principal will be repaid over time on a regular basis. A term loan has a set maturity date and usually has a fixed interest rate.
What are term loans & how do they work?
Term loans provide borrowers with cash if they meet certain terms. Although most loans are technically term loans, this term is typically used to refer to small business loans. They are used to purchase fixed assets, move to a new location, expand inventory, or pay for other business expenses.
What is a business term loan?
A term loan, also known as an installment loan, is a loan that gives you a lump sum of money as opposed to a line of credit. In exchange, you agree to abide by the terms and conditions that come with it. These include regular payments with interest and sticking to the set payment schedule. Business term loans can be secured or unsecured loans.