What is a 'Term Loan'
A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and a fixed or floating interest rate. For example, many banks have term-loan programs that can offer small businesses the cash they need to operate from month to month. Often, a small business uses the cash from a term loan to purchase fixed assets such as equipment for its production process.
BREAKING DOWN 'Term Loan'
A term loan is for equipment, real estate or working capital paid off between one and 25 years. The loan carries a fixed or variable interest rate, monthly or quarterly repayment schedule, and set maturity date. The loan requires collateral and a rigorous approval process to reduce risk of repayment. A term loan is appropriate for an established small business with sound financial statements and a substantial down payment to minimize payment amounts and total loan cost.
Types of Term Loans
An intermediate-term loan runs less than three years, is paid in monthly installments from a company’s cash flow and may have balloon payments. Repayment is tied to the useful life of the asset financed. A long-term loan runs for three to 25 years, is collateralized by a company’s assets and requires monthly or quarterly payments from profits or cash flow. The loan limits other financial commitments the company may take on, including other debts, dividends or principals’ salaries, and can require an amount of profit to be set aside for loan repayment.
Example of Term Loan
A Small Business Administration (SBA) loan encourages long-term financing. Short-term loans and revolving credit lines are also available for assistance with a company’s short-term and cyclical working capital needs. Maturities for long-term loans vary according to ability to repay, purpose of loan and useful life of the financed asset. Maximum loan maturities are seven years for working capital, 10 years for equipment and 25 years for real estate. A loan is repaid with monthly payments of principal and interest.
A fixed-rate loan payment remains the same because the interest rate is constant; a variable-rate loan requires a different payment amount when the interest rate changes. A lender may establish an SBA loan with interest-only payments during a company’s startup or expansion phase; the business then has time to generate income before making full loan payments. Balloon payments are not allowed on most SBA loans. The SBA charges the borrower a prepayment fee only if the loan has a maturity of 15 years or more and is prepaid in the first three years. Every loan is secured by all available business and personal assets until the recovery value equals the loan amount or until all assets are pledged as reasonably available.