Understanding Term Loans for Your Small Business

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Updated on Monday, January 21, 2019

Term loans
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If you need money to start a new business or to grow your existing one, a good option may be a term loan. In the complex, competitive and sometimes confusing world of small business financing, term loans are a straightforward way of borrowing. You receive a lump sum of money, less any fees the lender charges. You then pay back the loan in full, with interest, in regular, fixed payments over a set period of time. Hence, the name: term loan.

You’ve likely had similar loans if you’ve ever financed a car, borrowed money for college or bought a home. These loans are typically set up so most of your payment goes toward paying interest at the beginning of the loan. Term loans can usually be repaid early to save on interest, although some lenders may charge a prepayment penalty.

How do term loans work?

Banks typically offer fairly low rates on term loans but carry stricter requirements, such as high annual revenue and a strong personal credit score. The approval process on bank term loans is usually slower than for online applicants. There are short-, medium- and long-term loans depending on your cash needs.

Short-term loans

These loans are typically repayable in as little as three to 18 months. They are ideal for businesses with revenues that fluctuate seasonally or that require a small, quick influx of cash that can be repaid in the short term with incoming revenue. Repayment terms can be daily, weekly or monthly.

Medium-term loans

These loans typically last two to five years. They can be backed by collateral, either an asset you already own or the equipment the loan is being used to purchase. Other times, the loan can be unsecured. These can be an attractive option for helping a business open a second location, buy equipment, refinance debt or increase staffing.

Long-term loans

These loans can extend up to 25 years for just thousands of dollars up to millions of dollars. These can help a business undertake a large construction project or make a major purchase such as acquiring another business.

How hard is it to qualify for one?

A traditional term loan is generally attainable as long as you’ve been in business at least a year or two, have a good credit score and can show steady revenue, said Sandy Headley, vice president of Cleveland, Ga.-based Access to Capital for Entrepreneurs (ACE) Inc. and a banker for 20-plus years. It’s typically easier to qualify for a loan with a shorter term, but the interest rate likely will be higher.

Term loans are traditionally very popular with the business community, said Headley, but lines of credit, which can have low interest rates, also can be good options.“It just really depends on the use of the funds,” she said.

If a business needs money to address short-term cash flow problems, then a term loan likely isn’t the answer, Headley said. “But if you are going to make an expansion because you’re adding a new product line then a term loan is what you need,” she said.

Pros and cons of term loans

Here’s Headley’s take on the pros and cons of term loans.

Pros

  • The longer terms make payments more affordable.
  • The influx of funds help with cash flow.
  • Term loans provide the needed working capital to purchase equipment and inventory and to expand the business.

Cons

  • You have to be able to make the payment every month.
  • Term loans can have balloon payments at the end, which can cause anxiety with interest rates rising.
  • Collateral is almost always required, meaning you’re backing your own loan.

Term loan FAQs

Since term loans allow a business to borrow more money at a lower rate and over a longer term, these loans are tailor-made for specific projects, such as an expansion, equipment purchase or buildout.

A business with a good track record and good credit would be ideal to take advantage of these types of loans, their low interest rates, and the long repayment terms they can offer.

No one type of loan works for every business. Here are a couple of scenarios where other types of loan products might be a better fit.

If you have poor credit: If you have less-than-satisfactory credit, the term loan you apply for may come with a higher interest rate. That’s because a lender evaluates your loan application using both your personal and business credit scores. If you haven’t paid previous debts on time or at all, the lender considers you a higher risk of default.

If you are a new or start-up business: Your business likely won’t qualify for a term loan if it hasn’t been in operation for at least a year. The lender wants to see that you have enough cash coming in to meet the term loan repayment without stressing your business operations. because business operations should be helped by the term loan without it putting too much stress on cash flow. With little track record, the lender can’t accurately determine if you can likely make payments.

Shopping for term loans

There’s a wide-open market for term loans with banks, credit union and online lenders, as well as for alternative financing. Typically, you’ll find that term loans issued through banks and credit unions have the lowest interest rates. But to qualify at a bank or credit union, you typically need good credit and a strong business record. You’ll also need patience because the application and approval processes will take longer.

If speed is important, online business lenders may be a better option. But you should be aware that the rates they charge on term loans will likely be higher. It’s important to closely examine the numbers and the tradeoffs.

Fees

Fees vary by lender and financing product. That’s why it’s important to review your loan documents carefully. Here are some to look for in your offer:

  • Origination fee: This upfront fee is charged for processing a new loan.
  • Processing fee: These are other various underwriting costs that lenders may pass on to the borrower.
  • Documentation fee: This is fee for filing the loan application. Not all lenders charge this fee.
  • Late fee: The lender charges these fees when your payment is not made on time.
  • Broker’s fee: If you don’t work directly with the lender, this fee can be charged by the broker, or middleman, who helps to arrange the loan. Small businesses should carefully consider whether to use a broker.
  • Other fees: These can include closing fees, prepayment fees, guarantee fees, among others. Check the fine print before signing to know when your lender can charge you.

Other loan considerations

  • Secured vs. unsecured term loans: To mitigate the risk of default, some banks require assets or collateral to back a loan. This is a secured loan and the lender maintains a stake in that asset until the debt is paid off. By contrast, unsecured loans don’t have collateral and are riskier for lenders. To offset some of that risk, unsecured loans may come with higher interest rates and shorter repayment schedules.
  • Fixed vs. variable interest rate: If a loan has a fixed interest rate, then that rate remains unchanged during the entire term. The primary advantage of a fixed interest rate is its certainty. A variable rate on a loan can decrease or increase. Typically, variable-rate loans initially have a lower rate than similar fixed-rate loans. But if the index the rate is tied to increases — typically the prime rate — then you may end up paying more in interest over time than the fixed-rate loan.

What do you need to apply for a term loan?

Each lender has its own requirements, but the following are typical documents lenders require for a term loan application.

  • Tax Employer Identification Number (EIN): Your EIN is needed to request tax return transcripts from the IRS.
  • Tax returns: Tax returns show the health of your finances. You may need to provide copies of both your personal and business tax returns.
  • Balance sheet and income statement: These provide the most comprehensive picture of your finances compared with tax records or credit score.
  • Bank statements: The bank statements show your day-to-day management of cash inflows and outflows. This can reveal if you can manage a large sum of money and pay back your term loan.
  • Debt schedule: This helps a lender determine whether you can handle new debt and gives an accounting of all your debts, including loans, leases, contracts, and notes payable.
  • Driver’s license: This is how lenders obtain proof of identity.
  • Credit reports: The lender may pull a credit report on both you and your business.

Don’t be surprised if the term loan requires both collateral and a personal guarantee. Banks and the SBA typically prefer if the value of the collateral totals the loan amount. Alternative lenders are more lenient, but may require a security interest and a UCC-1 financing statements, which allows a creditor to take a lien against your property.

The bottom line

Because you can get more money at a lower rate and over a longer term, term loans are well-suited for bigger, longer-term business needs such as major equipment purchases, expansion plans or property buildout. The funds you get come at a lower rate, making it less expensive over the long term. These loans typically have more stringent requirements to qualify, but the terms may well make them worth it. As always, shop for your best deal and be mindful to read the fine print.

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