Growing a business requires financing to take advantage of market timing and advantageous circumstances. For instance, if customers are going crazy for your products and you don’t have the cash to keep them on the shelves, you’d want a loan to ramp up your production.
But not all business loans are created equal. Different products are appropriate for different use cases. One of the most versatile is the term loan, a longer-term, lower-rate product that is paid back in fixed increments — typically over several years.
So when should use you use a term loan? Here are five of the most common use cases:
When You’ve Got a Long-Term Project
Term loans are perfect for long-term projects. Typically, when you are bringing online a new store, new product line, or even expanding product, you won’t see an immediate return on your investment. So if you sink all of your cash into expansion, you’re likely to come up short.
Instead, taking out a term loan to finance the expansion lets you manage your cash flows on your long-term projects. The low, fixed monthly payments on a term loan make it more manageable in the short run, giving you plenty of runway for your project to get off the ground.
In other words, term loans are ideal for investing in longer-term growth projects.
When Affordability Is a Concern
If you’re operating on relatively slim margins or you don’t have a ton of revenue to support repayment, a term loan is ideal. Because because loans have longer terms and lower rates than most other financing options, they tend to be very affordable.
Too many business owners look only at interest rate (or total interest paid…), without paying attention to monthly payment. This is a huge mistake. The marginal difference between a 10% interest rate and a 20% interest rate is typically only a fraction of the total amount financed. But a two-year term loan is about 4 times more affordable than a 6-month cash advance or line of credit.
In other words, lower rates and longer repayment terms make term loans very affordable.
When You’re APR Conscious
That said, some business owners are highly rate conscious. And that’s okay, because term loans stack up well there, too. Because of their relatively simple structure and predictability, term loans are easier to structure, less risky, and easier to find capital for, so they tend to have lower APRs than merchant cash advances, lines of credit, and other financing solutions.
When You Need a Lot of Money
When you need a lot money (say, 50% of your revenue), a term loan is a perfect option. In fact, most large business loans are structured as multi-year term loans because they’re comparatively affordable.
The math here is simple: it’s a lot easier to repay a million dollars over 3 years than 6 months (in fact, unless your business is a cash-flow machine, a six-month repayment would be virtually impossible).
When You’re Just Starting Up
Businesses may also benefit from using a term loan to cover startup costs. With a term loan, you can get a larger loan without a larger payment — perfect if you’re still getting your revenues off the ground. Even with no revenue, a few thousand dollars a month is manageable over the short term if you have some money in the bank. In this way, a term loan can really maximize your startup capital.
When Predictability Is Important
A term loan can be a good option because it’s easy to predict (and plan for) fixed payments. Whether you’re trying to put together a credible business model or control costs, the predictability of term loan payments add some certainty to otherwise difficult-to-forecast cash flows.
The Downsides of a Term Loan
A term loan has its disadvantages too.
Most notably, term loans are repayable at a fixed rate (rather than a percentage of revenues like a merchant cash advance or a minimum payment like a line of credit), meaning that you are still on the hook for the full payment even if you aren’t making any money. “Debt is hungry.”
Also, unless you’re financing through friends and family, you’ll also have to prove that you have good credit and can support a term loan, which can be a daunting process—especially if you’re going through a bank.