A term loan is what most small business owners think of when they start looking for a small business loan.

If you’ve ever had a car loan or home mortgage, you’ve had at least one type of term loan. The “term” in “term loan” refers to the period of time in which you make payments—typically expressed as a number of years. Thus “term loans” refer to a loan that’s granted with a specific repayment period.

Term business loans are generally used to finance the purchase of assets needed by the business – think land, equipment, or a vehicle. The exact repayment term is determined by the useful life of the underlying asset for which the loan is used. For example, a small piece of equipment like a computer or copier might require repayment in two to three years, whereas land and buildings are frequently offered terms ranging from 20 to 25 years.

Term loans are sometimes secured by the assets they’re used to purchase, though other conditions frequently apply as well.

What is a Term Loan?

Term loans are sources of funding for businesses that, similar to more traditional loans or lines of credit, are paid back over a period of time in monthly installments.

Term business loans, unlike more traditional loans, are more often used to cover large purchases, like equipment, for a business. If the business owner needs to make a large purchase and doesn’t have the capital to cover it upfront, or else would rather not reduce their cash flow or liquid assets, term loans offer a good alternative. With a term loan, business owners can borrow a lump sum and get the cash upfront, while agreeing to a repayment schedule and terms, which may include a down payment, interest, fees or other conditions.

How Term Loan Payments Works?

Term loan payments combine an amortization of the debt. This means that each loan payment you make covers the accrued interest on the loan, and also a portion of the loan balance. Term loans usually come with fees that are set when you first take out the loan. These fees may be paid upfront or added to the loan balance. Be sure to ask your lender about this during the application process.

Generally, lenders require that you take out insurance on the assets you’re buying with the loan. Should you fail to make payments on the insurance or taxes on the assets, your lender has the option to advance these payments to protect their collateral and may add these costs onto your loan balance with interest.

Also, term loans usually have late penalties for any payments not made by a specified due date. Payments are made monthly, although a few financial institutions may offer other options, like quarterly payments.

With term loans for real estate, some lenders will offer loans spanning over long time periods, such as 20 years, but give borrowers the option of a shorter-term repayment schedule, of say five to seven years. These are known as “balloon” notes, since at the expiration of the five to seven years, there is still a principal balance due, called a “balloon payment.”

What Are Some Examples of Term Loans?

Term loans are useful to meet a variety of business needs. A restaurant needs to buy new kitchen equipment, including large items like a refrigerator, oven, dishwashing station and short order counters. The business is small and doesn’t have the capital to front the money for the purchases. The owner is hesitant to put such large purchases on a credit card, concerned about high interest rates and debt accumulation. A business term loan offers the restaurant a cash infusion to be able to pay for the new equipment in a lump sum total with just a small down payment. The restaurant can then make monthly payments to pay the business term loan back over a period of several months, maybe even years.

In another example, a hospital opens a new unit in a town and the nearby uniform supply store needs to quickly stock up on more scrubs and PPE to meet the surge in demand for medical uniforms and supplies owed to the sharp rise in staff at the hospital. The store needs capital to pay for the larger-than-usual inventory. That’s where a business term loan can help bridge the financial need and help tide the store over so that it can purchase the extra inventory without impacting cash flow and be able to meet consumer demand.

Pros and cons of Term Loans

There are benefits and watchouts with any business venture, including term loans and particularly any that involve lending where variables like repayment terms and interest could cost a business. Specific considerations for business term loans include:

Pros:

• Ability to borrow funds via term loans quickly to cover immediate needs
• Lower interest rates on term loans than credit cards
• Opportunity to boost credit care with on-time term loan payments

Cons:

• Potential for negative impact to credit if you fail to pay back term loans on time
• Approval time for term loans can take longer than other loans
• Penalties for late payments on term loans

Term Loan Approval Rates

Small businesses who seek out a term loan from a bank face considerable obstacles in getting approved. According to a survey in January of 2014, small businesses that sought term loans from big banks were approved less than 20% of the time. Those who applied with small banks had much higher approval rates, of around 50%.

Term Loan Interest Rates and Fees

Like any loan, with a term loan, you’ll be charged interest on the amount you borrow. How much interest you pay depends on the current rate, and the type of rate structure you negotiate.

The interest rate you’ll be offered depends on a variety of factors, including:

• The current index rate (lenders usually offer the Prime Rate, LIBOR, or a Treasury Rate, based on the type of loan)
• The perceived credit risk represented by your loan
• The length of the loan term

Term loan interest rates are either fixed or variable (also called “floating”). A fixed-rate means the interest rate will stay the same for the duration of your loan, regardless of what happens in the capital markets. (This means the best time to look for fixed-rate loans is when the market is low.) But keep in mind, in exchange for the assurance of knowing exactly what your interest will be for the loan term, you’ll have to pay a premium on top of the interest.

Variable-rate loans are based on an interest rate index, which is directly associated with the lender’s cost of capital. Borrowers agree to a rate that’s based on the index rate plus a defined interest margin, meaning that as the lender’s cost of capital goes up or down, the rate also fluctuates. This can mean a low rate, in the beginning, can, over time, become significantly higher — or lower.

For term loans of five to 10 years, it’s tough to predict whether a variable rate will stay low. But as you make more payments over time and lower the balance of the loan, the interest rate will have a lower impact on your total monthly payment amounts.

Closing Fees on Term Loans

Be prepared to pay certain fees as part of the cost of a business term loan, which could include:

• A commitment or loan fee (usually about 1% of the loan amount)
• Closing costs, which are determined by the cost of the lender’s lien on the loan collateral, and can range from 1% (for an equipment loan) to 7% (for a real estate loan) of the total amount

Why Take Out a Term Loan?

While credit cards are best for immediate expenses like travel or office supplies, and credit lines are primarily intended for cash flow management, term loans are meant for specific, high-cost purchases that will benefit your company over a longer period of time.

There are a few typical reasons a business would seek out a term loan:

• Equipment, machinery, and other tools for manufacturing, service, and repair
• Technology and other office equipment, such as computer equipment, phone systems, copiers, furniture, and point-of-sale (POS) systems
• Real estate, office space build-out, renovations, and new construction

Who Offers Term Loans?

Term loans are offered by commercial banks, finance companies, and other non-bank lending companies.

In addition, some equipment and vehicle manufacturers have divisions called “captive finance” companies that offer term-loan financing for the sale of their products.

Some non-bank lenders that specialize in financing working capital will also offer term loans to their established clients, although these loans can be more restricted than those offered by other types of lenders.

How to Apply for a Term Loan?

Like any business loan, applying for a term loan requires submitting specific information about your business and its owners. Your lender will likely want to know about the person(s) behind the company. You may be asked to provide information like resumes for all the principles.

To expedite the application process—and increase your chances of approval—have all your application materials ready, and be prepared to respond to additional information requests that may come up. The materials you’ll need may include (but aren’t limited to):

• A well-formed and detailed business plan that explains why you need financing, exactly what assets will be purchased with the loan proceeds, how you expect your business to benefit from this purchase, etc.
• Business financial statements for up to the past three years, including balance sheets and profit and loss statements (P&L)
• Tax returns for the business and its owners over the past three years
• A debt schedule
• Personal financial statements on all of the business owners
• The lease for the business premises, if applicable
• Financial projections for three years showing what you expect revenue and expenses to be, and demonstrating that operations will be able to repay the proposed loan
• Resumes for all business owners and key employees
• Information about the assets to be purchased, including a copy of the sales contract or purchase agreement, if applicable.

The lending institution will also obtain credit reports for your business, and, most likely, your personal credit reports. Check your business’ credit report before you apply, so you know what to expect.

The turnaround time for an approval decision can vary based on how quickly you provide all requested materials, as well as the complexity of your business and specific situation.

Keep in mind: some term business loans may have minimum or maximum size requirements for your business.

Before You Sign

It’s important to check whether the loan terms you’re offered include penalties or other costs. Penalties may be tacked on not just for late payments, but also for early loan repayment, particularly with fixed-rate financing. Later down the line, your business may grow and you could be in a position to make much larger payments, and thus pay the loan off faster. So it’s a good idea to know whether doing so will incur an extra fee.

It’s essential to do your homework in advance and read all documents carefully before signing. If your interest rate is variable rather than fixed, ask the lender about the timing of any future rate changes before you sign. And if you don’t feel you’re sufficiently familiar with financial terminology in the loan terms, consider having an outside expert, such as your lawyer, review the loan document before you sign it.

In addition, be sure to ask about your options for auto-pay (direct withdrawal), and whether these win you any discounts in the interest rate.

To Sum Up

A term lending is a good option for financing capital improvements, purchasing equipment, buying real estate, or other similar needs. Although term loans often include favorable rates, many businesses will experience difficulty qualifying with traditional lenders.

Like any loan—or, for that matter, any business arrangement—it’s important to know what you are looking to accomplish and to do your homework before applying. Be ready to consider smaller loan amounts or alternative approaches, keeping in mind that the success of your business is both the immediate and the long-term priority.