What Is a Term Loan?

Almost three quarters of American small businesses used some type of financing—including term loans—in 2016.1 A term loan can help businesses expand their operations by covering immediate cash needs.

With several types of financing available to small businesses, you might wonder how a term loan fits into your business plans. When your small business has a specific, high-priority expense, a term loan from a bank, credit union, or online lender can help.

What is a term loan?

Put simply, a term loan is a deal between a borrower and a lender where the lender provides cash up front and receives that money back through a series of smaller payments over a certain amount of time (repayment terms). As an incentive for the lender, the borrower also pays a percentage of interest.

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A business term loan helps business owners with large purchases thanks to the way installment loans work—it spreads the impact of one large cost over many smaller fixed payments (installments) to the lender. Similar to how a student loan helps students invest in their futures, this financial aid can help a small business purchase a new location, vehicle, or piece of equipment that will improve future profits.

While useful and often necessary for business growth, term loans of course come with a cost to the borrower. Beyond the monthly payments, these costs might include the following:2

  • Interest
  • A down payment (if buying real estate or another business)
  • An origination fee for starting the loan
  • Underwriting fees or closing costs

Whether you’re seeking business loans or your own long-term personal loan, don’t forget to include these additional costs in your planning.

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How do term loans work?

Loans from banks or credit unions are usually harder to qualify for and require a long term of several years, but they offer better rates. An online lender can get you a loan more quickly and with fewer conditions, but you should expect to pay more for that convenience.

Long-term business loans of three to ten years from a bank will usually carry an interest rate between 4% and 6%, depending on your credit history, cash flow, and other details. Banks offer secured loans, where businesses provide collateral in case of an unpaid balance, and unsecured loans, where the business doesn’t provide collateral.

You can find both short-term small-business loans (some as short as several months) and long-term loans from different online peer-to-peer lending or institutional lending companies, and their interest rates can fluctuate a great deal. Some might compare with bank loan rates, but other rates may be nearly twice as much.

Remember that a fixed-rate loan will keep the same interest rate from when you first sign that promissory note (which is a legal written record of the loan between two entities), but a variable-rate loan could end with significantly higher or lower rates than when you started the deal. Many borrowers prefer fixed rates for their reliability.

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Some small businesses also qualify for U.S. Small Business Administration (SBA) loans, which have impressively low interest rates thanks to their backing from the federal government. But you don’t apply to the SBA directly for these loans. Instead, you work through a bank or other lender to secure and repay the loan. As long as you meet the base eligibility requirements listed on the SBA’s site, you can reach out to a lender to see if your situation qualifies for SBA long-term financing.

What are some examples of term loans?

Let’s say a small clothing vendor has seen plenty of financial success and wants to expand to a new location in a nearby town. While they have plenty of cash flow, it would still take a long time to save up enough money to open a new store. A term loan lets the clothing company open that store right away so they don’t miss out on that extra income.

In some ways, a business loan works similarly to a short-term personal loan, like one used to buy a car. For example, a moving company with good credit could use the up-front cash from a loan to satisfy increasing demands with additional trucks. Other types of machinery required to run a business could also be purchased with a short-term loan.

However, business loans aren’t only for large single-item purchases. If a sports equipment store needs to quickly expand its inventory for a new season, a small loan with a short term can help stock the shelves just in time for the ski or snorkel rush.

Strengths
  • Borrow large sums of money for immediate needs
  • Improve your business credit score with successful loan payments
  • Receive lower interest rates than most credit cards and any small-dollar loans or payday loans
Weaknesses
  • Enter long-term debt with possible penalties for early repayment
  • Wait a while for loan application approval (shorter for online lenders)

Where do I get a short- or long-term loan?

Your local bank or credit union likely offers business term loans, and it could be a good place to look first. If you weren’t approved by a bank or if you need a shorter approval period, Lendio helps business owners shop for a variety of online loans, including short-term or long-term loans.

Sources

  1. U.S. Small Business Administration, “Small Business Finance
  2. U.S. News, “The Best Small Business Loans of 2018