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 either a fixed or floating interest rate. A term loan is often appropriate for an established small business with sound financial statements and the ability to make a substantial down payment to minimize payment amounts and the total cost of the loan.
How a Term Loan Works
In corporate borrowing, a term loan is usually for equipment, real estate or working capital paid off between one and 25 years. Often, a small business 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.
The term loan carries a fixed or variable interest rate – based on a benchmark rate like the U.S. prime rate or the London InterBank Offered Rate (LIBOR) – a monthly or quarterly repayment schedule and a set maturity date. If the money is being used to finance the purchase of an asset, the useful life of that asset has a hand in the repayment schedule. The loan requires collateral and a rigorous approval process to reduce the risk of default. However, term loans generally carry no penalties if they are paid off ahead of schedule.
[Important: 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.]
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 – but less than 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. 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 set aside for loan repayment.
Both intermediate-term loans and shorter long-term loans may also be balloon loans and come with balloon payments – so-called because the final installment swells or "balloons" into a much larger amount than any of the previous ones (no principal or a smaller amount of principal may have been paid along the way).
Example of a Company-Oriented Term Loan
A Small Business Administration 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 loan maturities are 25 years for real estate, seven years for working capital and 10 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; a variable-rate loan's payment amounts vary with 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. 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.