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 will share everything you need to know.
A business term loan is a lump sum of money you borrow from a lender, and paid back at a fixed interval— with interest — over a set period of time. Many businesses choose term loans because they don’t want to dip into their capital reserves but would rather allow a lender to finance their capital use (projects and business capital needs) at a fair price. In most cases you’ll pay off the loan monthly, however other payment terms might be available on a case-by-case basis for example, some lenders offer daily, weekly and bi-weekly repayment options in addition to monthly options. Repayment periods generally begin at 12 months and last up to 10 years.
Interest rates also vary by lender and by market conditions, but they can be either fixed or variable. Fixed rates stay the same, while variable rates change depending on the state of the market.
Term loans can stretch out over many years, the most common terms are 1, 2, 3, 5, 7 and 10 year terms. There are very few programs that extend beyond 10 years. Since a term loan repayment period is longer than many other types of business financing, it’s a highly desired program due to its low payments and predictable principal and interest repayment schedule.
Term loans are best when your business needs to invest in a longer-term enhancement or business improvement. Additionally, when the expected return on investment (ROI) is greater than the cost of the loan, the term loan can be a great choice. It's less desirable to use a term loan when you are in a temporary cash crunch as this could drag your business down.
Good use case: Anything where the usefulness of the investment is greater than (or not significantly less than) the term of the loan.
For example, if your business takes out a 5-year / $100,000 term loan to purchase inventory, which you will sell within the next 6 months, then it is not good use case, since the term of the loan is 5 years and the inventory would have been sold within the first 6 months of the 5-year term. You will be paying off the inventory for 4.5 years after it was sold. It would have been best to structure your term loan as a 12 to 18-month loan, opposed to a 5-year loan. We can also flip this scenario on its head - for disciplined business owners this could become a good use case, ONLY if you were to pay off the term loan once the inventory is sold and your business earned its profit for selling the inventory. Whereby, the 5-year term loan was actually paid back within 6 to 12 months.
In the above example you would have enjoyed low payments for 6 months, and the loan would be paid back early. But let’s be honest – most business owners find this type of discipline quite challenging.
Terms loans are also for businesses and owners that have a very good credit profile, since a term loan will carry the lowest combination of fully amortizing interest rates or factor rates and longest-term length, which equates to lower payments than the other business funding options.
Normally, a short-term loan would be selected for businesses with a less than perfect credit profile, as these products are easier to qualify for and can still be obtained at a reasonable price to term ratio.
A short-term loan is, by comparison, also useful for those businesses which are seasonal in nature or a business that is making a purchase where the usefulness of the thing or the service that the funds were used for is greater than (or not significantly less than) the term of the loan.
This type of loan is also utilized by those businesses looking to meet its short-term working capital requirements, as a short-term loan will be in repayment for less than 12 months. The rate of interest or factor rate and overall payment is generally higher due to the short-term nature of the repayment. It is common to find these loans being repaid daily or weekly, but not monthly.
Finally, a bridge loan is a type of a term loan that is useful for businesses that have run out of cash or are nearly out of cash, and are expecting to receive a longer-term loan soon. Lenders grant these types of loans only to those borrowers who are the most credit worthy. Sometimes the lender might want to use a business asset like a building or machinery as collateral, while the bridge loan is in repayment. However, there are many cases where a bridge loan can be acquired without any collateral.
Unsecured term loans are not secured by collateral, but secured loans are secured by some type of collateral, these loans are also called collateralized loans.
Examples of collateral
Secured loans will normally have lower interest rates and cost than unsecured loans since it's secured by some form of asset that the lender can sell in the event the business defaults on the loan. Many small businesses find it more difficult to get approved for secured loans because they lack the assets for a lender to resell in the event of default. A lender doesn’t always require a business’s owner to personally guarantee a secured loan, since the asset will generally provide that security. Additionally, secured loans typically have the highest loan amounts and longest terms.
Unsecured term loans will normally carry a higher interest rate and cost than a secured loan since if the business defaults on the loan, there is no guarantee that the lender will be paid any portion of the outstanding loan balance, and the lender has no asset to sell. It is very common that a lender that offers a business an unsecured loan will require the business owners to personally guarantee the loan. This means that if the business defaults on the loan, then the lender will have the right to pursue the business owners directly and personally to demand loan repayment. The maximum loan amounts for an unsecured loan are generally less than a secured loan and the term will also be less.
Whether your business is pursuing a secured or an unsecured loan, be sure to read our article “Tips to getting approved.”
The overall cost of a term loan will vary depending on how high or low of a risk the lender deems your business. For example, a business with a higher risk profile (to the lender) will likely be required to take on a shorter term and pay a higher interest rate and fees. Alternatively, a business with a lower risk profile (to the lender) will allow for longer terms, and pay lower interest rates and fees. Each lender will have its own risk model, which is why it’s very important for a business to apply with multiple lenders and then compare offers.
The good news is that all lenders who offer term loans calculate the payments in the exact same way, which makes this an easy program to compare. For you to calculate your term loan payment, you’ll need to know the term of your expected loan (number of periods), the interest rate of your loan and your loan amount. With that information, your business term loan payment can be calculated manually…but that is too much work.
Check out our term loan calculator where you can estimate your potential loan payments.
A business line of credit is revolving credit, allowing you to carry a balance that accrues interest. Think of it in the same way that a Credit Card works. If you don't use the line of credit, you don't have to make any payments. Once you draw from the credit line, as long as you make the minimum payment each month, you can either pay your balance in full or pay whatever you can afford, and keep in mind that your unpaid balance will accrue interest.
Conversely, a business term loan is installment credit. You receive a lump sum and make fixed daily, weekly, bi-weekly or monthly payments on it until it's paid off during a set period of time. You must start repaying the loan right away, whether you use the money immediately or not. Furthermore, unlike personal loans, most business term loans are limited to specific uses. A business line of credit, however, can be used for any business purpose you choose. Finally, term loans are generally available in larger amounts than business lines of credit.
As a new business or any business which has been established for less than 2 years, it is possible to qualify for a term loan under specific circumstances, but the likelihood is much lower than if your business has been more established. To qualify for a term loan, lenders will evaluate some of the following: time in business, business credit score, business assets and liabilities, business owners credit history.
All in all, lenders normally use the 3 C’s principle to evaluate businesses applying for loans:
The lender will check your personal and business credit report to assess the kind of borrower you and your business have been in the past. Whether you were an honest borrower or a difficult one for previous lenders to deal with. In case you were a difficult borrower, lenders will try to evaluate what caused it and whether it was due to spending beyond your ability to pay back the loan. This is called character.
Your business's revenue, free cash flow, or any collateral is considered while calculating your credit capacity by the lender. Greater revenue and free cash flow empowers your repayment potential and thus makes lenders confident, while lending you the money.
The capacity to repay the loan is also considered by the lender when they decide to set a loan amount for you. The business cash flow, existing expenses and your proposed new loan payment are considered to determine how much debt/expense payments the business can handle. If your cash flow is high enough to accommodate the existing obligations, including the new loan payments, your capacity will be seen as good.
However, in most cases, newly established businesses lack strength in most of these areas which are critical to a lender's decision making about whether or not your business will get approved for a term loan.
Don’t be discouraged, there is a light at the end of the tunnel for new businesses. Term loans are only one of many ways a new business can obtain the funding they need. Check out other business funding choices here.
Although each lender will request to review specific documents and information about your business, the following are items lenders normally assess when making a loan decision for a term-loan.
This is not an exhaustive list as each lender has different requirements, but it will get you started:
With Lendzero, applying for a business term loan is easy.
Step 1: Click on the Get Approved button above and answer a few basic questions about your business. We will inform you about your best options and how many exist (this will set your expectations).
Step 2: After this is complete, you will be asked to create a username and password to begin your electronic loan application. This process normally takes about 6 – 7 minutes (if you have all your documents easily accessible and ready).
To complete the loan application, here is what you will need to have handy:
Step 3: Once the application process is complete, we will send you the completed loan application for you to review and sign. Once you have signed for your application, the process is complete. You have officially applied and started your journey to receiving pre-negotiated term loan funding offers. Your Lendzero funding specialist will reach out to you to guide you through the remaining steps of the process, and provide the necessary guidance and support needed with the goal of successfully obtaining the proper loan.
