Picking the Right Term Length for Your Small Business Loan
June 7, 2021 | Last Updated on: July 24, 2022
June 7, 2021 | Last Updated on: July 24, 2022
When pursuing small business financing, it is important to understand your financing options including loans with various “term lengths.”
The term of a loan can be thought of as how long you will be making payments to pay back the loan on a regular schedule. You might be familiar with personal loans including mortgage loans, which are often 30 years, or auto loans which can be as long as 48 or 60 months. Business financing can be bucketed into three loan options: short-term, medium-term, and long-term loans. The term may also be referred to as â€śmaturity term.â€ť When you are considering funding options, you may be presented with different term lengths to select from.
Short Term: <1 year
Medium Term: 1-3 years
Long Term: 3-10+ years, potentially up to 20 years
Short-term loans (<1 year) are suitable for borrowers who have expenses with a limited time horizon. These loans are often funded with less extensive paperwork, and you can gain access to the funds quickly, sometimes within days.
Examples of expenses that may be suitable for a short-term loan are a one-time payroll shortfall, a repair of a piece of capital equipment, startup costs, a small office renovation, purchasing minor equipment, or a one-time inventory order. They are also suitable for emergencies or other one-off cash flow challenges.
When you are selecting a short-term loan, the expenses for that loan should be short-term! These loans are designed to satisfy an immediate and temporary need and are not meant for long-term capital expenses. It is best to select a short-term loan for temporary cash shortfalls, to bridge expenses for days, weeks, or months but not more.
Related Article | Term Loans for Building Your Business from Biz2Credit
One benefit of short-term loans, particularly if they are the first type of loan your business is taking, is that they can help build a new businessâ€™ credit score and credit history, showing future financial institutions that your business can be trusted to repay a future bank loan.
Another consideration regarding short-term loans is that you may be more likely to be approved for a short-term loan than a long-term loan. This is because short-term loans have a shorter time horizon which gives the lender more control. The application process for most business lenders requires at least some paperwork in the loan application including things like your tax return, bank statements, financial statements, personal credit score, a personal guarantee, and information proving annual revenue, but short-term loans typically require the least amount of paperwork.
Short-term loans are also less likely than medium and long-term loans to impose prepayment penalties. Short-term loans do often have higher interest rates (often starting at around 10%) and the loan amount may be smaller than what is available for longer-term loans.
Short-term bridge loans can help you get fast access to cash for your small business. The term â€śbridgeâ€ť refers to â€śbridging a gapâ€ť between your businessâ€™ need for cash and a not-too-far-away time when your cash flows will satisfy the need and pay off the debt. These loans have a short repayment period which can be as short as a few weeks before which you need to make loan payments. Lenders may require frequent monthly payments or may allow you to pay it back in a lump sum at the end of the term. Bridge loans can also have higher annual percentage rates, depending on the situation. You can explore bridge loans through traditional banks, credit unions, mortgage lenders, alternative lenders, or online lenders.
Invoice Financing, sometimes called Invoice Factoring, is another type of short-term loan where a small business (or any company) is advanced money by a lender before accounts receivable (unpaid invoices) are collected. For instance, if you are due to be paid $100K by a customer in 3 months, you could receive an advance from an invoice financing company now instead of waiting three months. Your small business pays a fee to the lender and the lender sets out to collect on the invoices. This can help small businesses get short-term cash more quickly than they would if they simply collected accounts receivable on schedule and absolves the company of the trouble of collecting on the invoices.
Business credit cards are another form of short-term financing that may appeal to small business owners. Similar to personal credit cards, business credit cards offer revolving credit and charge no interest if the balance is paid in full every month (within 30 days). If the balance extends beyond a month, interest will be charged unless there is a promotional 0% APR period. There is also a credit limit, or maximum amount that can be charged on the card, that can vary greatly depending on the size and creditworthiness of a business. One benefit of business credit cards is that the lender will have little or no scrutiny about what you use the funds for. Business credit cards should be used to alleviate short-term cash flow issues and are not meant for long-term capital expenses, because their interest rates are quite high.
A business line of credit is another option for a short-term loan. Business lines of credit have some similarities to business credit cards except that they provide access to cash instead of having to use a credit card to access the funds. To access a short-term line of credit, you can pull out a specific amount as you need it and you can repay with interest over time or all at once. One benefit of short-term lines of credit, just like a business credit card, is that the lender will have little or no scrutiny about what you use the funds for. Like credit cards, short-term lines of credit should be used to alleviate short-term cash flow issues and are not meant for long-term capital expenses, because their interest rates are quite high. Small business owner Brooks Conkle of Kea Marketing LLC prefers lines of credit instead of term loans because â€śIt provides us flexibility. I have a $50k business line of credit where I only pay the 5.5% interest as I use it. I think it makes for a great product in our situation.’
Finally, another type of small business loan is called a “Merchant Cash Advance.” In this type of loan, a lender will advance your money in anticipation of sales that they will take a cut of later on.
Related Article | Business Line of Credit – How It Works
Related Article | What is a Merchant Cash Advance?
Small businesses often choose Medium Term loans for expenses such as ordering inventory for a full year, opening a new branch or storefront, standing up a new team quickly or purchasing computer systems for your sales team. You will find that the banks and lenders will be more strict about whether they are willing to extend you a medium-term loan and the process may be just as intense as it is for a long-term loan. Repayment is typically once or twice a month. Interest rates may range from single digits as far north as 30%+. Medium-term loans may also impose prepayment penalties.
Related Article | The Basics of Term Loans
Companies typically take out long-term loans for major construction initiatives, equipment financing, buying other companies, or investing in major machinery that allows their business to run. These loans may require extensive detailed applications, good credit, large down payments, the commitment of collateral, and companies may have to commit to doing (or not doing) certain things during the loan term, referred to as a â€śrestrictive covenant.â€ť
For example, a lender might impose strict repayment terms or require that your business does not dispose of the machinery it uses to do business. Or the lender might mandate that you always have insurance. Long-term loans often have lower interest rates (compared to medium and short-term loans) but can have interest rates anywhere from low single digits for very stable and credit-worthy companies all the way to 30%+ for riskier companies or those with bad credit. Long-term loans may also impose prepayment penalties.
According to The Balance, â€śBusinesses should generally follow the rule of tying the length of their financing to the life of the asset they are financing.â€ť For example, if you need to purchase a piece of real estate that your business plans to use for 20 years, you might aim to select a 20-year loan. If you are purchasing a piece of equipment that you expect to last 15 years, you might aim for a 15-year loan. The idea here is that this asset will help your business generate revenue throughout those years so that you can service (or repay) the debt.
As a small business owner, choosing the proper term for your loans is important. These can have important ramifications on your financing options as well as your businesses overall health. One way to get expert advice on what loans suit your business best is to reach out to a certified public accountant (CPA). They will be able to provide expert advice based on your specific business, taking into account important metrics like cash flow. This way, you can make sure you are taking on a loan that will help your business grow and expand, not hamper it in its daily operations.
As always, be sure to check back here at our Biz2Credit Blog for all the latest information and news on opportunities for small businesses. We have been working diligently throughout the pandemic to keep our readers up-to-date, and we continue to do so, providing timely and vital information.