Term Loan

Term Loan — Definition and Overview

A term loan is a lump-sum loan repaid over a specified period with either a fixed or variable interest rate. Businesses—especially established small businesses—commonly use term loans to buy fixed assets (equipment, real estate) or to finance longer-term working capital needs. Lenders typically require financial documentation, collateral, and sometimes a down payment.

How Term Loans Work

• Borrower receives a one-time cash disbursement and repays principal plus interest according to a set schedule (monthly or quarterly).
• Interest can be fixed (payments stay the same) or variable (payments change with benchmark rates such as the U.S. prime rate or LIBOR).
• Loans are approved after a creditworthiness review and often secured by business assets or personal guarantees.
• Amortization schedules usually require periodic principal reduction; some loans include a final balloon payment that is larger than previous installments.
• Prepayment penalties are uncommon, though specific programs may impose them in limited cases.

Common Types by Term

• Short-term loans: Generally less than 1 year (sometimes defined up to 18 months). Often used when a line of credit is unavailable.
• Intermediate-term loans: Typically 1–3 years, repaid from operating cash flow.
• Long-term loans: Usually 3–25 years, secured by company assets and repaid monthly or quarterly. Longer maturities are common for real estate.

Both short- and intermediate-term loans can be structured with balloon payments.

Key Features and Considerations

• Lump-sum funding with predictable repayment schedule.
• Fixed or variable interest rates; variable rates track benchmarks.
• Collateral and owner guarantees often required.
• Down payments may be required to reduce loan size and risk.
• Useful-life of financed assets often influences loan maturity.
• Approval requires detailed financial statements and demonstration of repayment ability.
• Can free up short-term cash flow by spreading cost of assets over time.
• Potential downsides: restrictions on dividends or other financial commitments, and final balloon payments when present.

Example: SBA 7(a) Loans

• The U.S. Small Business Administration’s 7(a) program supports long-term financing for small businesses.
• Maximum maturities often depend on loan purpose and asset life—up to 25 years for real estate and generally up to 10 years for working capital and most other loans.
• SBA loans can be fixed- or variable-rate. Some SBA loans allow interest-only periods during startup or expansion.
• Most SBA loans do not allow balloon payments. A prepayment fee may apply only for loans with maturities of 15 years or longer.
• SBA loans are typically secured by business and personal assets until sufficient recovery value is established.

When to Use a Term Loan

• To purchase or upgrade equipment, vehicles, or property.
• To finance a fixed investment that generates returns over several years.
• To reduce short-term cash strain by converting a large expenditure into manageable payments.
• When predictable payments and a set maturity are preferable to revolving credit.

How to Apply

• Prepare up-to-date financial statements, tax returns, and a business plan or use-of-funds statement.
• Demonstrate creditworthiness and repayment ability.
• Be ready to pledge collateral and provide owner guarantees if required.
• Compare offers for interest rates (fixed vs. variable), fees, amortization, and any prepayment terms.

Pros and Cons

Pros
– Immediate access to capital.
– Predictable payment schedule (with fixed-rate loans).
– Often lower rates than short-term unsecured financing.
– Frees operating cash for other uses.

Cons
– Collateral and personal guarantees may be required.
– Variable rates introduce payment uncertainty.
– Balloon payments can create refinancing risk.
– Possible restrictions on other financial actions by the business.

Sources

U.S. Small Business Administration; Corporate Finance Institute; SoFi.