What You Need to Know About Term Loans For Business
When most of us think about loans and how they are repaid, we envision a bank issuing one large chunk of money for the purchase of something like a home or vehicle, which is paid back over a set period of time in equal payments. But while it’s a simple idea, loans like these come in many shapes and sizes. It’s important to have a good understanding of them all if you’re a business owner thinking about borrowing money.
Loans like the ones mentioned above are known as term loans, and for the most part they function exactly as we imagine they do. Once approved for a loan, a person or business receives a lump sum of money, which is usually tied to a specific use like buying a home. The bank and borrower agree on a total loan amount, interest rate, fees, and the repayment schedule. The borrower then makes regular payments that cover the principal (actual amount borrowed) and interest/fees. So that’s pretty simple, but is it all there is to know about term loans? There’s actually a lot more to it.
Term Loans for Small Business
The most common types of term loans that business owners will come across are intermediate- and long-term loans.
Short-term loans are typically not included in this conversation, because they are treated differently than a more traditional medium- or long-term loan. They are designed to provide emergency or bridge funding and are repaid over a much shorter amount of time – sometimes a little as a few months. If you’re looking for short-term working capital for your business you may not even want to get a loan at all.
The most common types of term loans for business are intermediate- and long-term loans.
- Typically have a term of less than three years
- Have larger payments
- Usually have smaller total loan amounts
Since intermediate-term loans are repaid more quickly and may not be as large as their long-term cousins, they are typically issued for smaller purchases like equipment or vehicles. They may also require balloon payments, which are large payments at the end of a term loan to cover the entire borrowed amount or principal. That could mean you spend a couple of years making only interest payments and then have to pay a lump sum when your loan comes due.
- Have terms longer than three years
- Can have much larger overall loan amounts
- May require large amounts of collateral, like a property or other high-value asset
- May limit the borrower’s ability to have other financial obligations
With payments that are spread over a much longer time period, long-term loans may be made for much larger amounts. This makes them more suitable for very expensive projects or purchases, like building new facilities or a buying an existing business. Most long-term loans will be amortized, which means that instead of paying interest every month and then owing a large amount of money at the end, you will be paying a fixed monthly rate that’s part interest and part principal. If you’ve ever had a mortgage, you’ll get how these long-term loans will work in the business world as well.
Where to Get Term Loans for Business
Since term loans are common, it’s not difficult to find a lender that has several options available. Banks and credit unions are by far the most traditional of lenders in this arena, with banks usually offering more in the way of business banking options besides just loans.
Traditional lenders like these are a great option for many business owners, because of their local and convenient branch networks and personal service. Having the ability to ask questions in person and make payments at a branch is important to many businesses, especially those with complicated or challenging financial needs.
The tradeoff for this convenience and level of service is that banks and credit unions are limited by their size and ability to offer larger loan amounts, particularly for smaller community-based institutions. Traditional lenders like these are also very heavily regulated, which can restrict their ability to offer more customized financial products.
They may also have specific lending policies that can prevent them from having too many loans to businesses in a certain industry or for a specific purpose. For example, many community banks closely watch their loan portfolios to avoid having too many funds tied up in things like commercial real estate or construction. This helps them mitigate their risk of loss if something big happens to devastate one particular type of business, like a natural disaster or sudden economic downturn.
Online and Alternative Lenders
We’re lumping these two together, because today most of the alternative lenders that you can find for your business are based online. Even though they’re not a bank or credit union, these lenders can offer many of the same financial products. Loans between the two types of entities can look very similar on paper as well, but there are several notable differences.
The biggest difference is that alternative lenders don’t typically offer deposit products to their customers. This means that the funds they’re issuing as loans must come from other sources, like investors. The separation of loan funds from deposits frees alternative lenders from much of the scrutiny that banks and other traditional lenders can face, since there is no need to protect depositors from loan losses. It also means the alternative lender may be more flexible with their loan policies and may open the door for loans to borrowers with less than perfect credit histories.
Alternative lenders usually offer one big benefit for business owners when it comes to loans and financing: speed. A term loan process with an alternative lender will be much faster than you might find elsewhere.
Pros and Cons of Term Loans for Business Owners
Term loans have many upsides to consider when applying:
- Fees, interest rates, and payments are clearly outlined at the beginning of the loan period and don’t typically change over the life of the term.
- Loan amounts can be very large to meet the demands of growing businesses and large-value business transactions.
- Can be used for a wide variety of financial purposes, from building a new facility to purchasing a piece of equipment or a vehicle.
The downsides include:
- Borrowers can sometimes be charged for paying off their loans early, known as a prepayment penalty.
- Large loan amounts and huge amounts of debt can cripple a growing business for the life of the loan if the owners aren’t prepared.
- Loans with variable interest rates can grow to be very expensive over time.
Getting a Business Term Loan
Borrowers are evaluated on several criteria when applying for a term loan. This usually includes:
- Business financial history
- Personal credit history
- Current financial situation
- Years in business
- Annual revenues
- Existing financial commitments
- Strength of business plan
Alternative lenders may have special programs or be able to offer loans to people and businesses who don’t meet the typical picture of a perfect borrower. The best way to find these lenders is through research and reading reviews or testimonials from other business owners that have experience with the organization. Even traditional term loans from a bank or credit union can be very expensive and may not be the best choice for a growing business, so it’s important to understand the options that are available before making a commitment to a years-long term loan.