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While it might seem like term loans are simple, there are many types of term loans, each with different repayment periods, interest rates, and other features. Understanding the different types of term loans and how they can be used to your benefit is important for everyone.
- Don’t be afraid to take a risk – you can use term loans to invest in your business and grow.
- However, it’ll cost you – term loans charge fees and interest, which means you’ll pay for the service of borrowing money.
- Have a plan – before taking on any loan, have a clear plan for how much to borrow, how you’ll use the funds effectively, and how you’ll pay the money back.
Understanding Term Loans
Term loans are a basic type of loan. You submit an application and, if approved, receive a sum of cash. The lender then sends regular bills, expecting you to make payments toward your loan balance. Each payment covers the accrued interest plus a portion of the principal.
You can use term loans for many purposes, such as purchasing equipment or buildings for your business (for example short term business loans), hiring new employees, or covering unexpected expenses. Depending you’re your credit, your company’s financial situation and your reasons for applying for the loan, the details of the loan you receive can vary wildly.
Types of Term Loans
There are many types of term loans, though they can largely be broken down into short-term, intermediate-term, and long-term loans.
Short-term loans are, as their name implies, those that you are expected to repay relatively quickly after receiving the funds. For example, the repayment period may last just a year or less.
These loans are usually used for small, unexpected expenses rather than larger projects or investments. Typically, they don’t require collateral either. In general, short-term loans can carry high fees and interest rates because they can be riskier to the lender.
Intermediate-term loans are those that last for more than a year, but not an exceedingly long time, often less than five or ten years.
These are popular for larger investments, but not massive ones that will take exceedingly long to repay.
Medium-term loans might be a common choice for something like buying a new vehicle for a business or getting funds to hire and train new employees that you’ll put to work in a new business location.
Long term loans are those that take the longest to repay. Depending on the reason for the loan, it can take decades before you pay one-off.
For example, a business might take on a mortgage to buy a new production facility and expect to take thirty years to repay the debt.
Long-term business loans usually involve some form of collateral. Most frequently, the asset purchased with the loan is used as collateral. Because there is collateral involved, interest rates can be lower than the rates charged on unsecured loans.
Features of Term Loans
Term loans are highly flexible. You can customize many of their aspects to fit your company’s needs. For detailed information on features of term loans check out small business loan terms. Alternatively, here are some features that are the same across all term loans.
- Secured or unsecured. Term loans can be either secured or unsecured, however loans that involve some form of collateral will have lower interest rates due to the reduced risk for the lender.
- Fixed term. Term loans have a fixed repayment period, called the term of the loan (hence the name term loan). For example, a ten-year term loan will be repaid over ten years, usually in the form of 120 monthly payments. Learn more about differences between short- and long-term business loans in our article.
- Cost varies with lender risk. Lenders set the interest rates and fees for term loans based on their perceived risk. They consider factors such as the borrower’s credit score, the loan amount, the term of the loan, and the borrower’s financial situation to determine risk. Riskier borrowers face higher interest rates and fees.
Pros and Cons of Term Loans
Term loans have many benefits, but it’s important to keep their drawbacks in mind too.
Some o the benefits of term loans include:
- Highly flexible. Almost any aspect of a term loan, including its rate, term, and repayment schedule, can be negotiated and adjusted.
- Lower interest rates. Term loans tend to have lower interest rates than things like lines of credit, credit cards, or personal loans.
- Business tax deductions. Business owners can take a tax deduction for interest paid toward term loans.
- Secured loans may be easier to qualify for. A secured term loan, such as one used to buy real estate, can be easier to qualify for than other types of unsecured loans.
- Collateral at risk. If you get a secured loan, the collateral involved is at risk. If you fail to make payments, the lender can repossess the collateral to compensate for its loss.
- Increase leverage on the balance sheet. Businesses must detail their debt on their balance sheet. Companies with too much leverage may be seen as risky by investors.
- Interest and fees. Borrowing money isn’t free. Any money paid in interest or fees reduces the company’s net profit.
Factors That Determine the Term Loan Eligibility
When you apply for a loan for your company, the lender will decide whether or not to fund the loan. There are no guarantees and you may find that lenders will refuse your application.
Some factors that influence your eligibility for a term loan include:
- Quality of credit. Your personal and business credit scores can affect whether you qualify for a loan. The higher your scores, the better your chances of getting a loan.
- Business plan. Lenders will want to know how you plan to use the borrowed money, especially if you’re borrowing money to start a new enterprise. Having a detailed business plan with a clear path toward profitability and making money to repay the loan will help.
- Business finances. Lenders will look at your business’s performance and existing finances to make a lending decision. Struggling companies might have difficulty borrowing money while those with strong revenues and profits should be able to borrow easily.
Floating Rate and Fixed Rate of Interest
One thing that is very important to know when applying for term loans is the difference between a floating interest rate and a fixed interest rate. Term loans can come with either type of rate.
Floating interest rates change over the course of the loan, typically based on market rates. Usually, the rate on the loan will adjust at fixed times, such as once each year. As the rate of your loan increases or decreases, so too will the monthly payments.
Usually, floating-rate loans have lower starting rates than fixed-rate loans, but they mean dealing with the possibility that your payment could increase.
Fixed-rate loans, by contrast, have a set rate throughout the life of the loan. The rate is usually higher than a floating-rate loan’s starting rate, but they offer the certainty of a fixed payment throughout the life of the loan.
How to Apply for a Term Loan for Business
To apply for a term loan, follow these steps.
1. Get your paperwork in order.
Lenders will want to see the details of your business and your plans for using the loan funds. Get all of the necessary paperwork in order before you start applying.
2. Apply with multiple lenders.
When you’re looking for any type of loan, it’s essential to compare offers from multiple lenders to get the best possible rate. Apply for loans with multiple companies to see which offers the best deal.
3. Compare your offers.
Once you get your loan offers, take the time to compare them. Look at things like the interest and rate and fees to see which loan will be the cheapest. Also consider things like the term of the loan, monthly payment, and collateral requirements. You might like to take a look at our list of the best short term business loans and compare the most recommended loan options.
4. Close on the loan.
Once you’ve settled on the lender you want to work with, you can close on the loan. The lender might ask for some additional documentation before you can sign on the dotted line.
Once you close on the loan, you’ll receive the funds and start getting regular bills.
Frequently Asked Questions (FAQs)
Before you apply for a term loan, make sure you understand how they work.