What Is a Term Loan?

A term loan provides borrowers with a lump sum of cash upfront in exchange for specific borrowing terms. Term loans are normally meant for established small businesses with sound financial statements. In exchange for a specified amount of cash, the borrower agrees to a certain repayment schedule with a fixed or floating interest rate. Term loans may require substantial down payments to reduce the payment amounts and the total cost of the loan.

Key Takeaways

  • A term loan provides borrowers with a lump sum of cash upfront in exchange for specific borrowing terms.
  • Borrowers agree to pay their lenders a fixed amount over a certain repayment schedule with either a fixed or floating interest rate.
  • Term loans are commonly used by small businesses to purchase fixed assets, such as equipment or a new building.
  • Borrowers prefer term loans because they offer more flexibility and lower interest rates.
  • Short and intermediate-term loans may require balloon payments while long-term facilities come with fixed payments.

Understanding Term Loans

Term loans are commonly granted to small businesses that need cash to purchase equipment, a new building for their production processes, or any other fixed assets to keep their businesses going. Some businesses borrow the cash they need to operate on a month-to-month basis. Many banks have established term loan programs specifically to help companies in this way.

Business owners apply for term loans the same way they would any other credit facility—by approaching their lender. They must provide statements and other financial evidence demonstrating their creditworthiness. Approved borrowers get a lump sum of cash and are required to make payments over a certain period of time, usually on a monthly or quarterly repayment schedule. 

Term loans carry a fixed or variable interest rate and a set maturity date. If the proceeds are used to finance the purchase of an asset, the useful life of that asset can impact the repayment schedule. The loan requires collateral and a rigorous approval process to reduce the risk of default or failure to make payments. As noted above, some lenders may require down payments before they advance the loan.

Borrowers often choose term loans for several reasons, including:

  • Simple application process
  • Receiving an upfront lump sum of cash
  • Specified payments
  • Lower interest rates

Taking out a term loan also frees up cash from a company's cash flow in order to use it elsewhere.

Variable-rate term loans are based on a benchmark rate like the U.S. prime rate or the London InterBank Offered Rate (LIBOR).

Types of Term Loans

Term loans come in several varieties, usually reflecting the lifespan of the loan. These include:

  • Short-term loans: These types of term loans are usually offered to firms that don't qualify for a line of credit. They generally run less than a year, though they can also refer to a loan of up to 18 months.
  • Intermediate-term loans: These loans generally run between one to three years and are paid in monthly installments from a company’s cash flow.
  • Long-term loans: These loans last anywhere between three to 25 years. They use company assets as collateral and require monthly or quarterly payments from profits or cash flow. They limit other financial commitments the company may take on, including other debts, dividends, or principals' salaries, and can require an amount of profit set aside specifically for loan repayment.

Both short- and intermediate-term loans may also be balloon loans and come with balloon payments. This means the final installment swells or balloons into a much larger amount than any of the previous ones.

While the principal of a term loan is not technically due until maturity, most term loans operate on a specified schedule requiring a specific payment size at certain intervals.

Example of a Term Loan

A Small Business Administration (SBA) loan, officially known as a 7(a) guaranteed loan, encourages long-term financing. Short-term loans and revolving credit lines are also available to help with a company’s immediate and cyclical working capital needs.

Maturities for long-term loans vary according to the ability to repay, the purpose of the loan, and the useful life of the financed asset. Maximum maturity dates are generally 25 years for real estate, up to ten years for working capital, and ten years for most other loans. The borrower repays the loan with monthly principal and interest payments.

As with any loan, an SBA fixed-rate loan payment remains the same because the interest rate is constant. Conversely, a variable-rate loan's payment amount can vary since the interest rate fluctuates. A lender may establish an SBA loan with interest-only payments during a company's startup or expansion phase. As a result, the business has time to generate income before making full loan payments. Most SBA loans do not allow balloon payments.

The SBA charges the borrower a prepayment fee only if the loan has a maturity of 15 years or longer. Business and personal assets secure every loan until the recovery value equals the loan amount or until the borrower has pledged all assets as reasonably available.

Why Do Businesses Get Term Loans?

A term loan is usually meant for equipment, real estate, or working capital paid off between one and 25 years. A small business often uses the cash from a term loan to purchase fixed assets, such as equipment or a new building for its production process. Some businesses borrow the cash they need to operate from month to month. Many banks have established term-loan programs specifically to help companies in this way.

What Are the Types of Term Loans?

Term loans come in several varieties, usually reflecting the lifespan of the loan. A short-term loan, usually offered to firms that don't qualify for a line of credit, generally runs less than a year, though it can also refer to a loan of up to 18 months or so. An intermediate-term loan generally runs more than one to three years and is paid in monthly installments from a company’s cash flow. A long-term loan runs for three to 25 years, uses company assets as collateral, and requires monthly or quarterly payments from profits or cash flow.

What Are the Common Attributes of Term Loans?

Term loans carry a fixed or variable interest rate, a monthly or quarterly repayment schedule, and a set maturity date. If the loan is used to finance an asset purchase, the useful life of that asset can impact the repayment schedule. The loan requires collateral and a rigorous approval process to reduce the risk of default or failure to make payments. However, term loans generally carry no penalties if they are paid off ahead of schedule.