A term loan is the most common form of small business loan, and what most people think of when they think of a loan. With a term loan, the length of repayment is set when the loan is made, and the borrower makes regular recurring payments over this time period to repay the loan.
What Is a Term Loan?
A term loan is a lump sum borrowed from a lender and repaid through regular recurring payments over a predetermined period of time. Interest rates for term loans may be fixed or variable. One example of a term loan is an auto loan, wherein you pay a fixed monthly payment until the loan is repaid.
Some loans are fully amortized, meaning that at the end of the repayment term the entire amount borrowed, plus the accrued interest, is paid in full. However, you may have a loan with a balloon payment. When a loan has a balloon payment, you still make monthly principal and interest payments as you do in a fully amortized loan. However, the payments do not repay the entire principal balance of the loan. At the end of the loan’s term, there’s a large sum of money—the balloon payment—that is payable as the last installment.
How Term Loans Work
To get a term loan, you complete an application and submit it to the lender for approval. The lender then determines the interest rate and repayment term for which you are eligible. Upon acceptance of the loan, you receive the funds, which you then repay through regular installments over the term of the loan.
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Who Term Loans Are Right For
Term loans are versatile and can be used for a number of small business needs, including working capital, equipment and inventory purchases, and business expansion. Additionally, if your business has existing debt with high interest rates or short repayment terms, refinancing business debt with a term loan may make your payments more affordable.
Businesses that may benefit from a term loan include:
- Businesses in need of working capital: Term loans can serve as a source of working capital for small businesses that need financing to maintain daily operations.
- Those seeking to refinance existing debt: Businesses with existing debt that want to extend the term or reduce interest rates may want to consider using a term loan to refinance business debt.
- Businesses making large purchases: Small businesses needing funds to purchase equipment or inventory may be interested in a term loan.
- Small businesses that need funds to expand: Growing businesses often use term loans to cover the costs associated with procuring real estate, financing the hiring of additional employees, and expanding operations.
The versatility of term loans makes them an attractive financing option for most small business owners. In general, term loans have an overall lower cost of capital than many other small business financing options, making them a more affordable means of funding as well.
Term Loan Costs
The costs associated with term loans are similar to those you may encounter with other financing options. Typical costs include the interest charged on the loan, prepayment penalties, origination fees, closing costs, and ultimately the annual percentage rate.
The typical costs associated with term loans are:
- Interest: The primary cost associated with a term loan is the interest rate, which is typically expressed as a percentage. The interest on your loan is paid as part of the regular payment.
- Prepayment penalties: Some lenders charge prepayment penalties on loans. If your loan has a prepayment penalty, you will be charged a fee for repaying your loan in full in advance of the full loan term.
- Origination fees: Origination fees may also be referred to as application fees or processing fees. These fees may be a fixed amount or charged as a percentage of your loan amount—typically 1% to 5% of the amount borrowed.
- Closing costs: Depending on the type of loan, you may have closing costs. These costs may include legal fees, recording fees, and other fees associated with the closing of your loan. Closing costs do not typically exceed 5% of the loan amount.
- Annual percentage rate (APR): The APR is a calculated interest rate that takes into account the interest rate as well as other fees charged in relationship to the origination of your loan—including origination fees and closing costs.
Not all term loans include all of the costs we have listed here. Your term loan may not have prepayment penalties, origination fees, or additional closing costs. The fees associated with a term loan vary by lender and by the type of loan you receive.
Types of Term Loans
While all loans with a fixed repayment period are considered term loans, there are different types of term loans. The most common of which are broken into three categories: short-term loans, standard term loans, and government-guaranteed loans.
The most common types of small business term loans include:
- Short-term loans: Generally, short-term loans are defined as those that have repayment terms of one year or less.
- Medium-term loans: A medium-term loan has a repayment period of one to five years, though terms may be longer depending on the collateral and purpose of the loan.
- Long-term loans: A long-term loan has a repayment term extending beyond five years, and is generally backed by a significant amount of collateral (e.g., large equipment, real estate).
- Government-guaranteed loans: Some loans are made by lenders and backed by federal agencies, such as Small Business Administration (SBA) loans or U.S. Department of Agriculture (USDA) loans.
Where to Get a Term Loan
Term loans are available from countless sources, most of which can be divided into three primary types of lenders. Traditional lenders like banks and credit unions generally offer both personal loans and business loans. Those looking for fast funding may prefer an online lender, while those who want to receive multiple loan options simultaneously may prefer working with a business loan broker.
Types of Term Loan Providers
Traditional Banks & Credit Unions
Established businesses with an existing banking relationship with a financial institution
Alternative Online Lenders
Businesses with less than two years of operations or poor credit
Business Loan Brokers
Small business owners wanting to shop multiple loan options with one application
The most common sources of term loans include:
1. Traditional Banks & Credit Unions
Small businesses with an established banking relationship with a bank or credit union may prefer to apply for a term loan directly with the financial institution they are familiar with. Loans from these sources generally have lower interest rates than those from alternative lenders; however, they are also more difficult to qualify for—requiring a higher credit score and longer time in business.
2. Alternative Online Lenders
Businesses that cannot meet the more stringent qualification requirements for a traditional lender may want to consider an alternative online lender. These lenders often have lower qualification requirements and are able to provide funding quickly—often within two days.
3. Business Loan Brokers
Business loan brokers serve as an intermediary between borrowers and a network of lenders. You complete one loan application with the broker, who then shops its network of lenders and presents you with multiple loan options for you to choose from. This allows you to select the offer that provides the rates and terms that best suits your needs without having to complete multiple loan applications with multiple lenders.
How to Get a Term Loan
To apply for a term loan, you’ll need to determine the purpose of the loan, how much funding is needed, and review the qualification requirements of each potential lender. Once you have narrowed the list of lenders to those for which you qualify, you’ll select a lender, complete the application, submit any required documentation, and proceed through loan approval and closing.
The six steps to apply for a term loan are:
1. Determine the Amount of Funding Needed
If you’re considering applying for a term loan, you likely have a specific need. Some lenders only provide financing for certain types of collateral, while others offer unsecured loans. Determining what you need the funding for and the specific amount of funding you need will help you select which lenders may best fit your needs.
Most lenders have maximum amounts that they are able to lend; if the amount of funding you need exceeds that amount, it won’t be worthwhile for you to apply for a loan from that lender.
2. Review the Lender’s Qualification Requirements
Each lender has a specific set of qualification requirements you must meet in order to be eligible for a loan. These requirements often include such things as credit score, annual revenues, and time in business. Prior to applying for a loan, you should review the lender’s specific requirements to ensure that you are eligible.
3. Select a Lender
Once you narrow down the list of lenders to those for which you qualify, it’s time to select a lender. You can often prequalify with a lender without it impacting your credit score, and without any obligation to accept the loan. By prequalifying with multiple lenders, you can select the lender that offers you the best rates and terms for your situation. Utilizing a business loan broker can simplify this process.
4. Complete the Application
The complexity of the loan application varies by the type of term loan for which you are applying. Short-term loans generally have a short application that asks basic information about your business and revenues. Longer-term loans require that you provide more detailed information regarding your business finances. Most lenders offer an online application process.
5. Submit Supporting Documents
As part of the application process, you may be required to submit supporting documentation to accompany your application. The documentation is used to verify the information you provided on your application, and to give the lender further insights into your business operations.
Some documents you may be required to submit include:
- Detailed description of how you’ll use all funds
- Proof of business ownership
- Loan application history
- Business overview and history
- Current business financials
- Year-to-date profit and loss (P&L) statement
- Current year-to-date balance sheet
- Business tax returns (two years)
- Projected financials (up to three years)
- Business licenses
- Business leases
- Personal financial statement
- Personal tax returns (two years)
- Owner resume
Once you have submitted your application and any required supporting documentation, the lender will review the information and begin the loan underwriting process. The duration of loan underwriting and loan approval varies by lender.
6. Loan Approval & Closing
Once the lender has reviewed your application and supporting documentation, they will make the decision as to whether or not your business qualifies for the loan. If you are approved for financing, you will receive a loan agreement that details the rates, terms, and payments for your loan. You should carefully review this document prior to signing to ensure that you fully understand what will be required of you as the borrower.
Once you have agreed to the terms, the loan can be closed. Depending on the loan, this may happen at the same time as the acceptance of the loan agreement, or may be completed in a separate closing. Some loans, like those used to purchase real estate, have more involved closing processes, whereas an unsecured loan can often be finalized simultaneously with the acceptance of the loan agreement.
Once the loan is closed, you will be advanced the loan funds either by check or through an electronic transfer into your business bank account. Loan closing starts the clock on repayment. If your loan payment is due monthly, your first payment is typically due one month from the closing date. Your lender should explain to when your first payment is due, but if you aren’t clear, you should ask the lender at closing, or as soon as possible afterward.
Pros & Cons of Term Loans
Term loans offer many advantages, like predictable payment amounts, a defined repayment term, and affordable interest rates. Conversely, some disadvantages to this type of financing include requiring higher credit scores and personal guarantees from the business owners, as well as having additional fees associated with them.
Pros of Term Loans
Some advantages of a term loan include:
- A predetermined number of payments: Term loans have a defined repayment term with a fixed number of payments.
- Predictable payment amount: With a term loan, your payments are predictable and predetermined. Even with variable interest rates, your payment amount is fixed for a defined period of time.
- Lower interest rates: Term loans generally have lower interest rates than alternative financing methods, such as credit cards, invoice financing, and merchant cash advances.
Cons of Term Loans
Some disadvantages of a term loan include:
- Requiring a personal guarantee: Providing a personal guarantee for a loan means that if your business is unable to repay the debt, you are personally liable to repay the loan from your own assets.
- Additional fees associated with them: In addition to being charged interest on your loan, you may also be required to pay origination fees, prepayment penalties, or other fees for a term loan.
- Higher credit score requirements: Term loans often require higher credit scores than alternative sources of financing.
Alternatives to Term Loans
Term loans are a great way of financing for many small businesses; however, there are additional financing options that may be a better fit depending on your specific funding needs and your business. If you aren’t certain that a term loan is the right option for your business, you may want to consider a business credit card, line of credit, or invoice financing.
Some common alternatives to term loans include:
Business Credit Cards
For businesses that have recurring working capital needs, a small business credit card can be a good alternative to a term loan. Many business credit cards offer introductory periods at 0% APR, as well as cash back or rewards programs. These credit card incentives can be beneficial if your business regularly uses credit cards. Having access to a business credit card can be an immediate source of funds for your small business expenses.
Business Line of Credit
A business line of credit offers a revolving source of financing that operates in a manner similar to a credit card. With a line of credit, the lender approves a maximum loan amount, and you are able to draw and repay up to that amount over and over without the need to reapply for financing. One advantage that a line of credit has over a term loan is that you are only required to pay interest on the amount of principal you have drawn.
Invoice financing allows businesses to borrow money based on the value of their unpaid customer invoices. You select the invoices—typically invoices must be payable within 90 days—and the lender advances you up to 100% of the value of the invoices. The advance is then repaid through regular installments.
Term Loan Frequently Asked Questions (FAQs)
What is an example of a term loan?
A common example of a term loan is an auto loan. Auto loans are made with a defined repayment period and are repaid via fixed monthly payments. At the end of the repayment term, the loan has been paid in full.
What are the types of term loans?
Term loans are generally classified by the length of repayment. The primary types of term loans are short-term loans with repayment terms of up to one year, medium-term loans with terms of one to five years, and long-term loans with repayment terms of greater than five years.
What is the difference between a term loan & a demand loan?
A term loan is a loan that is repaid by regular payments spread over a defined period of time. Conversely, a demand loan is paid upon demand of the lender, meaning that the lender can demand repayment in full at any time.
Term loans are a common source of small business financing, providing borrowers with defined payment amounts and a stated length of repayment. These loans can be used for a variety of different purposes and are offered with varying repayment lengths. Additionally, due to the fixed payment amounts, term loans allow small business owners to easily budget for payments.
If you’re seeking a term loan to finance your next business endeavor, LendingClub offers small business loans of up to $500,000. Repayment terms range from six months to five years. You can prequalify online in minutes and, if approved, receive funding in as quickly as five business days.