What Is a Term Loan? Definition and Examples
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Summary:
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. Term loans can include business loans with both longer and shorter terms. Qualifying for a term loan can mean meeting strict requirements, so they’re best suited for well-established companies that show a solid financial background.
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.
If you fail to fulfill these commitments, the consequences will be dire. You could lose your business and personal assets or, at the very least, drastically damage your credit, making it very difficult to get a new loan in the future.
While you can get a term loan for personal use, such as a student loan, for the purposes of this article we’re going to focus on term loans for small businesses. However, it’s important to note that with any type of loan — such as personal loans, car loans, mortgages, and business loans — rates and loan terms can vary a lot by lender, so it’s important to comparison shop.
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What is a term loan?
A term loan is a type of small business loan that can help a company invest in the future and expand its business. They range from short- to long-term loans and involve getting a lump sum of cash upfront. In exchange, you agree to pay the loan back with interest and to adhere to a specific repayment schedule.
Term loan rates, requirements, and repayment
Term loans come with fixed or variable interest rates and may require a down payment or collateral in some cases. They are most commonly used by small businesses for fixed assets such as equipment or a new building.
While business term loans can be difficult to qualify for, they usually have lower interest rates and more favorable repayment schedules than other loans. They often come with monthly payments, or you might pay quarterly. You could also have a balloon payment. Loan amounts start relatively small and increase into the millions.
Where to get term loans
You can acquire term loans through a traditional bank or credit union or through online lenders. While traditional institutions will often offer the best interest rates, going through an online lender can be quicker and carry less stringent requirements. You may pay for that convenience, however.
Example of a term loan
The Small Business Administration (SBA) offers term loans and can be a great resource for experienced business owners who want to grow their companies. The limit for SBA loans is $5.5 million, and the requirements to qualify can be quite rigid, but they also offer the most favorable rates and loan conditions.
SBA loans usually offer fixed interest rates and never come with balloon payments. The maximum maturity for an SBA loan is 25 years, usually used for real estate, but you can also get shorter-term loans (about 10 years) for other business purposes. SBA also offer microloans of up to $50,000. These can be used for start-ups or expansion, but not for purchasing real estate.
SBA’s up-to-$50K microloans probably shouldn’t be confused with microloans or microcredit intended to help the poor, particularly in underdeveloped countries. While the latter can be for very small amounts where “micro” seems a suitable prefix, these SBA-guaranteed loans to U.S. small businesses are only “micro” in the sense that they are smaller than the much larger loans SBA also guarantees.
If you choose to seek an SBA loan, you will need to fill out SBA Form 1919 and submit it to an SBA-participating lender. The SBA doesn’t disburse the business loans directly, but they do insure them.
What is a term loan good for?
Term loans are usually best for well-established small businesses with a proven track record of financial stability who are looking to expand and grow their company. While they’re ideal for buying real estate or other fixed assets, there are many other appropriate uses for these small business term loans.
Extra space or equipment
For example, a shop that sells bath and body products is doing very well and wants to lease a space to open a new store in another part of the city. While they are showing a positive cash flow, they want to keep that cash handy for other uses. In this case, a term loan makes sense because they can more quickly expand to a new location and start generating more revenue.
Another good reason to take out a term loan is to purchase new equipment. Perhaps you could use a new machine to help manufacture your products more efficiently. Or, if you’re in the transportation industry, you might need to acquire new vehicles to further grow your business.
Expanding inventory or funding operations
Sometimes companies will also use term loans to expand their inventory. You can bet when Peloton bikes first came out, for instance, sporting goods stores were scrambling to stock those expensive pieces of exercise equipment.
Other business owners will take out term loans to finance their month-to-month operations, and there are lenders who have loan programs for just this type of situation.
Types of term loans
Depending on your needs, there are a few different kinds of term loans to think about before applying. Important considerations to factor in are what the loan is for and how long it might take to pay it back. A loan counselor can also help you define your objectives more clearly.
Short-term loans
Short-term business loans can range from a few months to a year. They are best suited for a purchase that you expect to pay for itself pretty quickly, such as new inventory. A short-term loan amount can be easier to qualify for, but the interest rate will likely be higher.
Intermediate-term loans
Intermediate term loans usually mature in one to three years, and are repaid on a monthly schedule. You can borrow more money with an intermediate-term loan: up to $500,000, or sometimes even $1 million, depending on your circumstances. A loan of this size is useful for opening a new location or buying expensive equipment.
Long-term loans
When you take out a long-term loan, you are allowed to borrow significantly more money — into the millions. You have anywhere from three to 25 years to repay one of these loans. Long-term loans of this size will usually require business assets for collateral, such as real estate or equipment, and may also require a down payment.
How to qualify and apply for business term loans
If you have poor credit or lack experience, you might find it difficult to qualify for business term loans. In many cases, no collateral is required, which makes it a much riskier proposition for the lender, hence the stricter requirements to get the loan. A secured loan, such as a car loan, is less risky for a lender, which means you’re more likely to qualify.
But if you have an established company and can document your business cash flow and a net profit for at least a couple of years, your chances of being approved for the term loan improve dramatically. You will also need to show good or excellent personal and business credit history and demonstrate a solid plan for how you will use the loan. The life expectancy of the asset you’re purchasing will also be factored in.
How do I apply for a term loan?
- Paperwork: First you will want to assemble all of the necessary paperwork required to process your loan. This includes, but is not limited to, personal and business financial records, tax returns, profit and loss statements, income statements, business licenses, and records of current or previous debts.
- Find a lender: Next you will need to shop for a lender. You can start by talking to banks or credit unions, or you can look into online lenders. An online marketplace can be handy because interest rates and loan terms vary wildly between lenders. This option allows you to fill out a single loan application and receive offers from multiple lenders to review and find the best deal.
- Compare offers: When comparing offers, you will want to carefully review the total cost of the loan because it can be deceptive. You may be tempted to go with the highest loan amount that offers the lowest interest rate, but that might not actually be the best deal for you. Keep in mind that fees imposed by the lender can add thousands of dollars to the loan.
A loan might include origination fees, processing fees, and prepayment penalties. Many lenders charge prepayment fees because if you pay off the loan more quickly, they lose out on interest payments. Shop for a business loan that doesn’t carry prepayment penalties if you think there’s any chance you might be able to repay the loan early.
Pro tip — If you qualify, loans from the Small Business Administration (SBA) can be a great resource for your company that’s looking to expand its business and generate more income.
Checklist for applying for a term loan
When you apply, make sure you have all the following:
- Tax returns
- Bank statements
- Profit and loss statements
- Income statements
- Personal financial records
- Business license or certificate
- Records of existing and past debts
- Proposal for the use of the loan
Pros and cons of term loans
Prudent advice — Small, short-term business loans can be a great way for companies to build their business credit scores.
FAQ
What defines a small business?
The Small Business Administration defines a small business as an independently owned and operated for-profit company that is located and doing business in the United States or U.S. territories. Though this definition is straightforward, it is also incomplete. Since it says nothing about the number of employees or total revenue, it could include both small and very large companies. For this reason, agencies like the SBA need to take either the number of employees or the company revenue into account.
What makes a small business small?
Defining size in terms of number of employees or total revenue makes things more complicated, and criteria vary wildly by industry. It also depends on whom you ask. The SBA, the U.S. Census Bureau, Healthcare.gov, and the IRS provide guideline that are complicated and often contradictory. So, if you seek help from a government agency for your small business, you’ll have to carefully review the small business guidelines published by that agency to know if your business qualifies for whatever program you’re interested in.
The complex guidelines of the SBA
In the case of the SBA, you can consult that agency’s table of size standards for a breakdown by industry and business type. If you know your business type and can find it on the table, you should be able to determine if your average annual revenue or average employee count satisfies the “small business” criteria. If you want to get an impression of what the SBA considers “small” in a broad sense, you’ll find this more difficult.
At the time this article was prepared in mid-April of 2022, the August 2019 version of the SBA table was still in effect. Here is some visual analysis of that table’s contents to give you an idea of its complexity:
About the most you can say in a general sense is that, for a decent number of business types, having $8 million or less in yearly income and 500 or fewer employees has a good chance of qualifying your business as a small business. But, really, there’s no substitute for finding the right entry for your specific company on the SBA table. If you first split the business types into those judged on the basis of dollar amounts and those judged on the basis of employee counts, no qualification standard applies to more than 25% of either of those two groups.
Actually, there may be one substitute for using the SBA table. The SBA also provides its Size Standards Tool for government contractors. Going through this tool’s Q&A process may help you determine if your company qualifies as a small business in the eyes of the SBA.
What does fixed vs variable interest mean?
If you take out a personal loan, for instance, you’re usually dealing with a fixed rate loan. This means that, throughout the life of the loan, your monthly payment will remain the same. When you have a variable interest rate, on the other hand, your loan payments will go up or down as the annual percentage rate fluctuates. Since the average person can’t predict the changes in interest rates, it can be more challenging to budget for variable-rate loans.
What are balloon payments?
In the case of certain short-term or intermediate-term loans, you might be looking at a balloon payment when your term loan matures. While you may have relatively predictable loan payments throughout most of the life of the loan, a balloon payment is one large payment made at the end of the loan term. If it’s a big loan amount, we could be talking about tens of thousands of dollars. It’s important to plan ahead for a balloon payment so you can satisfy the terms of your agreement and keep your good credit intact.
Other reasons businesses get term loans?
As you’ve learned, companies most commonly get term loans to finance the expansion or growth of their business, through the buying of fixed assets and real estate. Some businesses may also use term loans to finance their month-to-month operating costs, and many lenders have specific programs designed for this. A company might also want to take out a smaller, short-term loan to help build up their business credit score as they plan for long-term business growth and the future loans that could help finance it. Still others may get term loans to start a new business.
Key takeaways
- Term loans are a good option for well-established, profitable companies looking to expand their business.
- They can be used to buy or lease real estate, enabling a business, for example, to relocate to a bigger facility or expand to include a new location.
- Term loans can also help purchase new machinery, inventory, or equipment to streamline your business operations and create more revenue.
- An SBA loan is a great option for small business owners who can meet the strict qualifications.
- If you don’t qualify for traditional lenders, or hope to get the money more quickly, try looking into online marketplaces.
- When applying for business term loans, be prepared to demonstrate a solid plan for the use of the loan, and make sure to have all your paperwork in order.
What if you can’t qualify for a term loan?
Because of stricter requirements, qualifying for term loans can be difficult for some business owners. If you don’t show decent cash flow and a profit, or if your credit history is poor, you may not achieve loan approval. You should not simply give up after you’re declined once, however. If you take some time to explore the variety of business loans and business lines of credit available, you may find financing that you can qualify for and that suits the needs of your business.
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