Your business is picking up steam and ready to grow. The only problem? You don’t quite have enough funding to get there.
It doesn’t help that you’re not really sure where to begin with small business loans, either. For example, what is a term loan? What about a working capital loan?
If you don’t know about these loan options, you could be missing out on financing your business. Keep reading to find out what these loans are and which one is right for your business.
What Is a Term Loan?
A term loan is basically your standard-issue commercial loan.
When you get a term loan, you get a loan from your bank with a specified repayment schedule and a fixed or floating interest rate. Usually, this type of loan is ideal for a business that is established enough in their finances to make a substantial down payment. This will help minimize the ultimate cost of the loan.
What It’s For
You know who a term loan is for. That begs the question: what is a term loan used for?
Typically, in commercial financing, term loans are used to finance expensive purchases that will significantly bolster revenue over time. In plain English, this usually means the purchase of equipment, real estate, and working capital.
When small businesses take out term loans, they usually use them to purchase fixed assets. A more established business might take out a term loan to acquire the cash they need to operate from one month to the next.
How It Works
Because of this, term loans have some variety in terms of how they are structured.
As the name implies, term loans have a set term allowed for the recipient to pay back the value of the loan. Most of them operate on a set schedule, requiring a payment of a specified amount at fixed intervals through the duration of the loan.
They also tend to have a set maturity date, which is when the principal amount of the loan is due to be repaid to the investor.
The interest rate can also vary between loans. Some have a fixed interest rate, while others have a floating interest rate based on a benchmark rate, like the U.S. prime rate.
Types of Term Loans
In general, term loans can be classed into three types:
- A short-term loan
- An intermediate-term loan
- A long-term loan
The names tell you much of what you need to know about the loans.
A short-term loan usually has a term of a year or less and is typically offered to companies that don’t qualify for a line of credit.
An intermediate-term loan usually runs up to three years at most and is paid in monthly installments based on the recipient’s cash flow.
Finally, there are long-term loans, which are usually between three and ten years, though some can run as high as 20 years. These loans use your assets as collateral and usually require monthly or quarterly payments drawn from your cash flow or profits.
Term loans are beneficial in set circumstances.
As a rule, term loans are best for established small businesses with sound financial statements which they can leverage alongside a substantial down payment.
From there, the pros of term loans depend on what you’re trying to accomplish. For example, if you’re trying to weather seasonal income gaps or manage short-term operational costs, a short-term loan can be a great option for you.
Otherwise, term loans offer the most benefits to companies looking to undertake major capital improvements or large capital investments. These projects are significant enough to justify the length of the loan and set payments throughout the life of the loan.
That said, there are downsides to term loans if you don’t fit within certain categories.
If you’re a small business trying to manage your debt but you don’t have a great track record managing other loans, the bank won’t look favorably on you.
They also look at your capital and collateral–specifically, what assets can be converted to collateral if necessary–so you may be out of luck if you don’t have anything to bring to the table.
What Is a Working Capital Loan?
Now that you understand the essentials of how a term loan works, let’s take a closer look at its counterpart, the working capital loan.
As the name implies, a working capital loan is used to finance a company’s everyday operations (i.e. working capital). This means that the loan works in exactly the same way that ordinary working capital would work in its place, rather than funding large purchases.
What It’s For
Where a term loan can be used for more general purposes, a working capital loan is used to smooth out peaks and valleys in a company’s yearly revenue stream.
For example, let’s say you’re a manufacturing company producing goods for retailers. Most retailers make their sales in the fourth quarter (due to the holiday season) which means that manufacturing companies often do most of their business cyclically.
While they may be highly productive in the fourth quarter, this may not be enough to keep the company fully operational for the rest of the year, when sales are significantly down. In this case, a working capital loan can help level out the difference so the company can continue to operate optimally in the off-season.
How It Works
Because a working capital loan is designed to help a company manage periods when they don’t have as much working capital, they work rather differently than term loans.
Where a term loan is often used for significant short-term purchases or capital-building and require a long repayment period, working capital loans are only meant to address temporary operational costs, such as payroll and rent.
Because of this, working capital loans are typically short-term business loans which must be repaid in as little as four months.
In addition, since the loan is designed to cover your cost of operations, the loan amount you receive is based primarily on the cost of running your business. This month-to-month cost is typically far lower than the cost of a major purchase, which means that working capital loans are often relatively small.
The combination of a short loan term and a relatively small loan amount translates into a higher-than-average interest rate. This is because it costs the same for a bank to give you a small loan compared to a large one and they need a higher interest rate to ensure it’s worth it to give you the loan.
Types of Working Capital Loans
There are many types of working capital loans, but here are a few common ones:
- Accounts receivable loans
- A business credit line
- Factoring or advances
An accounts receivable loan is when you use your receivables (money owed by customers) to receive financing. This is usually equal to a reduced value of the receivables pledged.
A business line of credit is a lot like a personal credit card, in that you can continue to use and repay it as often as you’d like.
Factoring or advances are similar to accounts receivable loans, except that the loan is based on future credit card receipts rather than unpaid invoices.
One of the foremost benefits of a working capital loan is that unlike a term loan, you don’t need to have collateral in order to acquire funding.
In addition, because the loans are short-term solutions to temporary operational problems, you can usually get them quickly. You can also use them on whatever you need–so long as it falls under the general category of working capital.
It also doesn’t require an equity transaction, which means that the business owner (you) remains in full control of their business.
Of course, there are a few disadvantages of working capital loans, some of which are tied to the benefits.
For example, some working capital loans are unsecured. This can be good news for businesses who don’t have any collateral to put down in order to secure a loan. However, this option is only available to businesses with a high credit score, as the bank needs proof that they’re going to get their money back.
In addition, working capital loans are often tied to the business owner’s personal line of credit. This can be bad news if you’re trying to get a loan in the first place, and defaulting on a loan will hurt your credit score.
Figuring Out Finance for Your Small Business
Now you can answer the questions, “What is a term loan?” and, “What is a working capital loan?”
So the real question is, are you ready to make the most of your financing?
If so, check out our blog for more useful tips and tricks, like these 10 personal finance tips for small business owners.