Finance 101 - 12.21.2016

Term Loans 101: Term Loans Explained

Whether you need funds to start a new business or to grow your existing business, you have likely heard of a term loan as one of the options.

A term loan is the most straightforward type of small business loan: You borrow a certain amount of money from a lender and you agree to pay back the loan plus interest over a set period of time (called the term... hence the name!), with the principal fully amortizing over that term. Payments are typically made monthly.

There are no frills like drawdowns, revolvers, variable payments, etc. Just money now, with set payback terms.

A Note about "Term"

Most small business term loans come in short- (less than 1 year), medium- (1 to 5 years), and long-term (more than 5 years) varieties. As a general rule, the shorter the term, the easier the loan is to get--and the higher the interest rate.

Short-term small business term loans look a lot like merchant cash advances (very high rates, very aggressive payback terms, often including daily or weekly payment). Medium- and long-term small business term loans look more like mortgages (lower rates, monthly repayment).

Side note: Long-term small business term loans are typically only available for commercial real estate or from a bank/SBA lender, which means they're much harder to get approved for.

Pros and Cons of Term Loans

Pros

  • Affordability. Because they have a longer term, they send to be more affordable than other, shorter-term small business loan options.
  • Amount. Because they're more affordable, you can typically qualify for more money than you could with other, less-affordable lending options.
  • Planning. Because payments are predictable, it's much easier to plan for payments. This is especially true in comparison to variable rate or variable payment products.
  • Rate. Term loans tend to have lower rates and more generous payback terms, especially when compared to other small business loan options like merchant cash advances or lines of credit.

Cons

  • Harder to Get. Because they have longer terms, creditors are exposed to greater uncertainty risk. As a result, the approval and diligence process tends to be more strict than it is on other types of small business loans.
  • Less Flexibility. Because they have fixed repayment terms, term loans tend to be less flexible than other small business loan options, especially those with variable payments.

What about Collateral and Personal Guarantees?

Almost all term loans require both collateral and a personal guarantee.

The value of the collateral required will vary from lender to lender. Banks and SBA typically want the loan to be "fully" or almost fully collateralized... meaning that the value of the collateral equals or exceeds the loan principal. Non-bank lenders typically want collateral, but aren't as strict about it's value (or will collateralize specific assets, such as equipment purchased with the loan proceeds). In any event, expect a security interest and a UCC-1 financing statement.

As for a personal guarantee, they're "market" terms, meaning they're required by almost every small business lender in the United States (including the United States itself, in the form of the Small Business Administration!). So expect to sign an unconditional personal guarantee unless (1) your business has at least $20MM in annual revenue or (2) you're entering into an atypical transaction not available to most business owners (e.g., venture debt).

Best Uses

Because you can get more money at a lower rate and over a longer term, term loans are best used for larger, longer term needs. They're particularly well-suited for financing specific projects like an expansion, equipment purchase, or buildout.

Summary

Term loans are an excellent source of longer-term financing for your business. They are harder to get, but the terms make them worth it... if you have a specific need in mind. Expect to sign a personal guarantee and pledge your business assets as collateral. And don't forget to plan ahead, they typically take a little more time to get than a line of credit or merchant cash advance.


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