Whether you are a growing startup business or an established corporation, there are many reasons why you might need some extra funds to accomplish your goals. Access to funding can help a business owner cover the cost of important equipment or software that will lead to more sales. Simply put, sometimes you need to borrow money to make money.
There are a lot of financing options available for businesses, which can be confusing if you are not familiar with the terminology. Since you’re reading this article right now, it’s likely you could use some funding for your business. We’ll go over the key points of a term loan, so you can feel prepared when making your financing decision.
We understand how overwhelming it can be when looking into financing for your business. Our goal is to help make it as smooth as possible. We have many more articles on a variety of business financing options to help educate you further.
What is a Term Loan?
A term loan is when a business or individual borrows a set amount of funds from a lender and agrees to pay it back in equal installments over an agreed-upon period of time. The sum of money borrowed is broken down into equal payments, ranging from one year for smaller loans all the way up to 20+ years for larger assets. Lenders typically offer fixed interest rates and require payments are made monthly or quarterly.
Most companies opt for a term loan when they need equipment, a new building, or working capital and pay it off between one and 25 years. Business term loans are pretty versatile, so you can usually work with lenders to tailor them based on your specific needs. During difficult economic times, it may be necessary to borrow cash just to cover the operational costs from month-to-month. Many lenders today have established term-loan programs specifically for that purpose.
Depending on the type of loan, it may be necessary to make a large down payment in order to reduce the installments and, ultimately, the total cost of the loan. This is common for large purchases such as real estate or work-related vehicles. In addition to the monthly payments, there may be other costs such as origination fees, underwriting fees, and of course, interest, so you’ll want to be sure to include those in your budget if necessary. Interest rates will vary depending on the companies credit history, cash flow, and other pertinent details.
Types of Term Loans Explained
Term loans are categorized by the length of scheduled installments. There are three types of term loans; short-term, intermediate-term, and long-term. The actual term lengths for each type of loan vary somewhat by the lender.
Short-term business loans can be offered in place of a line of credit and run between a year and 18 months on average. The interest rates are slightly higher on short-term loans, but you pay less than you would over a longer period of time.
An intermediate-term loan hits the sweet spot right in the middle and typically extends payments for one to three years. These are particularly useful for businesses that need funding for a project but don’t have access to investors.
Finally, long-term loans run anywhere from three to 20+ years for substantial financing needs. These are usually reserved for established businesses with a credible financial history. If the funds borrowed are being used to purchase an asset, the useful life of a said asset may affect the repayment schedule.
What You Should Know About Term Loans
A formal loan agreement between the borrow and the lender must be established. It should outline the details of the loan, such as repayment schedule, interest rate, and all other commitments.
Some lenders may require you to provide collateral to reduce their risk of the loan. During the application process, you’ll need to provide access to financial information for the business, such as bank statements, credit history, and tax records.
Each lender will have their own fine print in the agreement, such as prohibiting the business from taking on additional debts. Some may require that you have business life insurance to cover the unexpected, but most term loans don't have penalties for paying off the loan ahead of schedule. One good perk to term loans is the interest paid on the loan each year is usually tax-deductible.
The “5 C’s” of Credit
Most lenders use the 5 C’s when considering loan terms. This is a system that weighs certain characteristics and the conditions of the loan to gauge financial risk. The five characteristics are character, credit capacity, collateral, capital, and conditions
Your business's character is reflected by the credit history. They are looking to see that you have managed other loans well. Some lenders might even ask for professional references as proof of good character.
The credit capacity is evaluated by doing a full analysis of your financial statements to determine what you can payback. The biggest thing they’ll be looking for is the amount of any other debts vs. your cash flow and revenues.
Secured business loans require some form of collateral. A company's collateral consists of assets that can be used to back or secure the loan in case of default. The lender will assess the collateral's current market value and its estimated resale value.
The lender will look into the total amount of money the business owns. This includes cash flow, savings, equipment, and real estate. All things that could be used as an alternate payment source if necessary.
Your lender will likely want to look into the expected revenue and expenses of the business. They will evaluate how well your industry is doing, why you’re taking out the loan, and how much you’re asking.
These characteristics provide a quick overview of what lenders will be looking for when determining a loan. If you are strong in these key points, you’re more likely to get approved for what you need. Character is listed first because it is one of the most important elements. All of them are essential, but character shows that you have integrity and commitment to your business.
Business Financing Options
There are other financing options available to business owners other than term loans. You may want to look into a business line of credit. A line of credit for your business is beneficial because the lender will give you a set amount of funding to stay within, but you can use as much or as little as you need. After you pay it down, you can borrow from it continuously as needed.
Business credit cards are another helpful financing solution. Every business owner should probably have a business credit card or two in their back pocket. The majority of cards today come with rewards and cashback, so you would be silly not to take advantage of those perks. Having a business credit card allows you to free up cash flow when needed and manage your funds appropriately. They can help you categorize spending for budgeting and tax purposes, all while earning free airline tickets!
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Term loans are good for businesses that need to cover an expense but want to spread the cost out over an extended period of time. All businesses can benefit from term loans, whether you’re a startup tech company needing to build credibility or an established business looking to expand locations.
Term loans can be tailored to meet your specific needs. A short-term loan is ideal for a newer business or a small expense that can be paid off pretty quickly. Intermediate-loans mature around three years and cover medium-sized business expenses such as new equipment or hiring a new employee. Lastly, a long-term loan covers the big expenses and typically has a term life of about 20 years. These loans are usually reserved for established businesses with impeccable credit history.
Each lender will have its own set of standards when determining a borrower's creditworthiness, but the 5 C’s are pretty common practice. As long as you stay on top of your bills and remain committed to your company’s reputation, you should have no problem obtaining the funds you need. If, for some reason, you’re missing some of the characteristics that lenders are looking for, there are a variety of other financing solutions available.