One major marker of success for an entrepreneur is the need to expand. With small businesses generating 3 out of 5 new jobs creating in the U.S. each year, it’s no surprise that a variety of financing exists to help small businesses grow.
Consider a term loan to purchase new equipment, remodel an office or hire qualified new talent. This type of financing can help keep you in the race for a larger market share in your industry.
Check out this quick guide to understanding and securing business term loans.
What are Term Loans?
A term loan is a lump sum given to a business over a set term and repaid at a fixed interest rate. In rare cases, variable interest rates may be used, but generally, repayment terms are set. The standard length of time for a term loan is 1 to 5 years.
A term loan works similar to a car loan or a mortgage. You borrow a set amount of money and it’s repaid in equal installments. These loans are commonly offered by traditional lenders like banks and credit unions.
The approval process and interest rates vary between lenders. Expect a range of $2,000 to $5 million dollars when applying for a business term loan.
Annual percentage rates range from 6% to 99% depending on your business credit history. If you don’t have a business credit history, a personal credit score may be used to determine your creditworthiness.
With a strong personal credit score, you can expect lower interest rates to cover your business loan. Some low rate bank loans expect both a strong business and personal credit score along with a high annual revenue in order to qualify.
Loans from traditional lenders also take longer to fund as they take care to ensure you have the ability to repay the debt. Once approved, the lending term with a bank is bound to be longer and the rates cheaper than other term loan sources.
Who Offers Term Loans?
Brick and mortar banks, online lenders and the Small Business Administration are three places to find a variety of term loan options. There are pros and cons to all three options depending on your current financial situation.
Online lenders offer a faster funding process the convenience of an online application. The downside to online lenders is that they generally apply higher fees to the loan and shorter repayment periods. Some loan repayment periods are as short as three months.
Online lenders offer more lenient borrowing requirements than traditional banks, however. The higher fees and shorter repayment are to account for the higher risks the lender assumes when approving a larger pool of applicants.
The Small Business Administration offers loans through banks and online lenders. These loans carry strict criteria for approval because they are backed by the federal government. SBA loans do provide extended repayment lengths and higher loan amounts.
An SBA loan might have a term of 25 years offering loans of up to $5 million. The type of SBA loan and how the money is used help lenders determine the term length and amount. SBA loans carry some of the lowest interest rates available making them a great option for term loans.
What Should You Use a Term Loan For?
Term loans are a great source of financing when you need to expand your business. The low rates and long repayment periods can give you the flexibility you need to generate long term growth.
Moving to a new location or buying new business equipment gives you the chance to make major profits before the end of your loan term. Hiring new talent or training programs for existing talent are all great options for term loans because they help you meet your goals for business growth.
Avoid using term loans when having financial problems. Unless your business is rapidly growing, a term loan can quickly become a liability. The added financial debt will drag down your business making growth unnecessarily challenging.
Choose term loans to cover specific purposes that can provide measurable results. When you look for large sums of cash before you have a plan, it can make determining the return on investment impossible.
How to Pick the Right Term Loan
Choose a term loan based on its ability to create a return on investment. If you have the option to choose the length of the loan, calculate how long should take before profits begin. Ensure your business begins to profit from the loan well before the loan matures.
Term loans follow an amortization schedule. Like a mortgage loan, most of your initial payments go toward interest. Towards the end of your loan term, the bulk of your payments begin to go toward the principal amount.
Choosing a term length that allows you to profit first can give you the advantage of repaying the loan early. Early repayment can save you thousands of dollars in interest depending on the amount of the loan. Check with your lender to ensure there is no prepayment penalty in your contract.
Here are three common types of term loans to choose from:
- Shorter-term loan – Popular with online lenders, a term loan with a repayment period of a year or less can be great when looking for immediate cash to cover a growth-related expense. Funding on shorter-term loans is often immediate and more relaxed requirements. The fees and interest rates are higher on these loans. The lender might also require much more frequent payments.
- Intermediate-term loans give you the flexibility to finance larger assets the help your business grow financially. The repayment period might be bi-weekly or monthly depending on the lender. Intermediate-term loans time for your investment in your business to generate a profit. Consider using the profits from your investment to fund loan repayments.
- Long-term loans include larger loans for the best applicants and generally have repayment lengths of three to ten years. Loans over $1 million dollars might have a much longer repayment term. Collateral is required for long-term loans in case you become unable to pay over the long term. are always collateralized and run from 3 to 10 (or sometimes 20) years. These loans are best for long term projects like new construction on a building.
Lenders have a variety of terms and conditions that apply to each borrower. Some loan terms may be negotiable while others are a minimum requirement of that lender. Here are a few key terms to know when reviewing loan information to determine whether the loan works for you:
- Secured vs. Unsecured Term Loans: A secured loan requires that you provide collateral in order to get the loan. Collateral can include a personal or business asset. If you operate a high revenue business, your options for collateral are more diverse than if you are just starting out. Collateral gives the lender something tangible to take in the event you aren’t able to repay the loan. Unsecured debt is typically more expensive because the lender has less protection against default borrowers.
- Fixed vs. Variable Interest Rate: The type of interest rate you receive will greatly impact your payment amounts. A fixed interest rate is usually ideal when managing major changes within your business. Fixed rates are set for the life of the loan. A variable interest rate can go up and down depending on a variety of factors. When the interest rate changes, the payment amount changes which can be problematic during seasons of slow sales or if the payment outpaces your return on investment.
Disadvantages of Term Loans
While there are many great advantages of term loans, there are some disadvantages to keep in mind. Borrowers with good credit ratings and high annual revenue may have better options than term loans.
For example, term loans offer less flexibility than lines of credit. Repayment on a term loan begins immediately after funding. A line of credit gives you access to a lump sum of capital over time with less immediate repayment requirements.
Less qualified borrowers incur high fees on shorter-term loans. Lending amounts are smaller meaning the possibility of needing more than one financing source is high. This can mean more lenders and repayment plans to manage.
The best option for term loans come from the SBA. Asking the federal government to back your loan is no less stringent than applying for CIA security clearance. The SBA has strict requirements and a slow due diligence process to ensure your ability to repay is high.
Term loans generally require collateral which is bad news if you are just getting started in your business. When you have no business collateral to offer, personal collateral might be requested instead. Personal collateral can include your house, retirement account or anything else of value owned by you or your spouse.
For more information on choosing the best loan to fit your business needs, visit our website.