Starting a business is hard. Keeping it going is harder.
And often, keeping it going means having enough money to face short-term and long-term business expenses. Young businesses can rarely pull in enough revenue to do this on their own, which is why loans play such an integral part in a start-up’s journey.
Business term loans are one type of business financing that can help you keep the lights on in your business and propel you towards success.
In this guide, we'll break down everything you need to know about term loans including how they work, when one is right for you, and how to apply. We’ll also explore alternative solutions that may better suit your business.
What is a business term loan?
A term loan is when a business borrows a lump sum of money for a specified period of time from a financial institution—like a bank—at an agreed-upon interest rate to use as working capital for its business expenses.
Here are some important things to remember for business term loans:
- Principal + interest payments. Each month, you'll pay one lump sum installment that includes a portion of your principal amount borrowed, and interest accrued.
- Fixed vs. variable term loan rates. The interest rate you pay on a business term loan is either fixed or variable. A fixed rate means your regular payments will stay the same for the life of the loan, while a variable rate means your payments could change over time.
- The “term” of the loan varies. The term is how long you have to pay back the loan, ranging from one to ten years, sometimes even longer. The repayment terms can be categorized into short, intermediate, and long-term loans (more on this later).
- Secured vs. unsecured term loans. A secured loan is when the borrower offers up collateral (something of value) to the lender in case they can't repay the loan. An unsecured loan doesn't require any collateral but often has a higher interest rate because it's riskier for the lender.
One example of how a business term loan works
Let’s say a window cleaning business wants to borrow a business loan of $50,000 from their bank. They need the money to purchase safety & cleaning equipment so that they can expand into two new metropolitan areas.
The loan agreement may stipulate that the loan must be repaid within five years at an interest rate of 7% per year.
In this case, the business owner would need to make fixed repayments of $990.06 per month for 60 months to repay the loan in full.
Pro tip: When planning your loan repayment terms, skip the pencil and paper and use an online calculator to make things faster and more accurate.
How do small businesses use term loans?
When it comes to small business finance, term loans are some of the most versatile funding options out there. They can be used for a wide variety of business purposes, such as:
- Purchasing inventory or supplies
- Repairing, maintaining, or upgrading equipment and machinery
- Investing in marketing or advertising campaigns
- Hiring new employees
- Opening a new location
- Making renovations to their current space
Types of business term loans
When it comes to different types of term loans, the biggest difference is repayment. There are three types of repayment periods available.
- Short-term business loans
- Intermediate-term business loans
- Long-term business loans
Each of these small business loans has different characteristics suited to different business needs.
Let’s break down the key differences between each.
- A short-term loan has a repayment period of a year or two. They tend to have higher interest rates (8–13%), but the good news is that you don't necessarily need great credit to qualify. These loans are best used for businesses with strong cash flow and collateral looking to make a quick purchase or expand quickly. But keep in mind your monthly payment will be higher.
- An intermediate-term loan has a repayment period of 2-5 years. The interest rates are lower than short-term loans, but you'll need good credit to qualify. These loans are best suited for businesses that are established and have a strong cash flow, but need a larger sum of money, like for equipment financing.
- A long-term loan has a repayment period of 5-10 years, sometimes even longer. The interest rates are lower than intermediate-term loans, but you'll need excellent credit to qualify. Traditional banks and credit unions offer these loans for major business expenses like real estate purchases or large-scale expansions.
How to choose the right term loan for your business
Now that you know of the different types of term loans, you can decide which one is right for your business. The best way to do this is by taking into consideration the following three factors:
- Your business’s needs. What are you looking to use the loan for? Are you trying to finance a short-term project, or do you need a longer-term solution? Your answer will help you determine which type of term loan is right for you.
- Your business’s cash flow (how you can afford to repay). Do you have a strong cash flow? If not, you may want to consider a short-term loan with a lower interest rate to avoid putting strain on your business, no matter how tempting borrowing more might be.
- Your personal credit score. Your credit score will be a factor in determining whether you qualify for a loan and, if so, what interest rate you’ll pay. If your credit score isn’t in the best shape, you may want to consider a short-term loan or other lending options to give you time to improve your score before you apply for another loan down the road.
Who qualifies for a term loan?
Any business can apply and receive a term loan if it can show that the borrowed money is in good hands, will be put to good use, and has a strong chance of yielding a profitable return.
While qualifications can vary from one lender to another, there are some core considerations shared among all institutions.
The lender will look for:
- Strong business credit history (so they can trust you’ll pay the loan back)
- Healthy cash flow (reassurance that you’re not drowning in debt)
- Outstanding debts (to get an idea of your other liabilities that could affect your financial obligation to them)
In addition, some lenders may require collateral, such as real estate or equipment, in order to qualify for a secured loan.
If you’re not sure whether you qualify, the best thing to do is talk to a banker or financial institution about your options. They’ll be able to help you determine which type of loan is right for your business and walk you through the application process.
When is a term loan not right for me?
While term loans may be a standard issue for a lot of businesses, they’re not the most accessible or best-suited financing option for everyone.
Here are a few cases where a term loan may be out of reach or a bad fit for your business:
- When you have poor credit. If your credit score is below 640, you'll have difficulty qualifying for a term loan. If you do qualify, the interest rates will be high, which could make repayments difficult. You may want to look into other financing options, such as a short-term loan or line of credit.
- When you need money quickly. Term loans can take weeks or even months to be approved and funded. If you need money quickly, you may want to consider a short-term loan or line of credit, which can be approved and funded in a matter of days.
- If you're a startup or new business. Startups and new businesses often have a hard time qualifying for traditional loans because they don't have a track record or history of financial success that ticks a lender's underwriting process. If you're a startup or new business, you may want to look into other financing options.
How to apply for term loans
You want to make sure you're prepared before applying for a term loan. In this section, we'll cover some best practices for acquiring a business term loan the right way so you can get the most out of one.
1. Know your lenders
Start by researching prospective lenders. You may find that while banks may offer favorable interest rates, their application and approval processes are too tedious and complex for your situation.
There are online lenders who may be a better financial fit – but you'll never know until you do some digging. For US based businesses, the Small Business Administration (SBA) is a great resource for finding lenders who work with businesses of your size.
2. Establish what you need the loan for
Before you start shopping around for a loan, you should have a clear understanding of how much money you need and what you'll use it for. In some cases, you may even need to present a structured roadmap or business plan to show lenders.
This will help you determine which type of loan is right for you and make it easier to compare offers from different lenders.
3. Get your personal and business credit scores in check
Both your personal and business credit scores can be one of the most important factors in qualifying for a loan because they can indicate your company's financial health.
It's important to know where your credit stands before you start shopping around. You can get a free copy of your credit report from each of the three major credit bureaus – Experian, Equifax, and TransUnion – once every 12 months through AnnualCreditReport.com.
4. Have your financials ready
In addition to your credit score, lenders will also look at other financial factors when considering you for a loan, such as your annual revenue, cash flow, and debt-to-equity ratio. It's important to have a clear understanding of these numbers before you apply for a loan so you can present yourself in the best light possible.
5. Anticipate additional costs
There are a few other costs you should anticipate when taking out a term loan. If you know them, you can get a more accurate understanding of the overall cost of borrowing and compare offers more effectively.
- Origination fee – A fee charged by the lender for processing your loan. This can be a flat fee or a percentage of the total loan amount.
- Processing fee – A fee charged by the lender for gathering and preparing your loan documents.
- Late fee – A fee charged by the lender if you make a late payment on your loan.
- Utilization fee – A monthly fee charged by some lenders if you don't use all of the loan funds.
- Broker's fee – If you work with a loan broker, they may charge a fee for their services.
- Prepayment penalty – A fee charged by some lenders if you pay off your loan early.
- Commitment fee – A fee charged by some lenders if you're approved for a loan but don't use it.
- Documentation fee – A fee charged by the lender for preparing and filing your loan documents.
- Closing fee – A fee charged by the lender when your loan is finalized.
As you can see, there are a number of different fees that may be associated with taking out a term loan. It's important to factor these in when comparing offers so you know the full cost of borrowing.
6. Gather your documents
No matter who your lender is, it’s a good idea to have the following items at the ready when applying for a term loan.
- An employer identification number (EIN).
- Your business license.
- A few years of business tax returns.
- Articles of incorporation or formation.
- Financial statements from the past two years.
- Personal financial statements from all owners of 20% or more of the business.
- A detailed business plan.
- Your debt schedule (record of other current debts you owe).
Pros and cons of term loans
Why you might love them:
- Planned payment schedule. For many businesses, the predictability of their repayments helps them make more accurate cash flow projections. A term loan, by definition, must be paid back on a specific schedule. However, there can be some variability if you don't have a fixed interest rate.
- Loan amount and terms tailored to your business. Lenders pay close attention to your business plan and needs in order to provide a suitable amount that you can use flexibly. And you can often choose a repayment schedule that works for you.
- Builds business credit. Making timely payments on a term loan can help you build business credit, which can be helpful down the road if you need to apply for additional financing.
- Frees up cash flow. Because term loans are paid back in fixed monthly payments, they can help free up cash flow that would otherwise be used to make larger, one-time payments on things like equipment or inventory.
Why you might hate them:
- Interest expenses. Depending on the market, lender, and your credit history, a term loan’s interest rates could put a dent in your pocket that your business isn’t equipped for in the future.
- May be difficult to qualify for. Term loans are typically only available to businesses that have strong credit scores and a long history of profitability. This can make them difficult to qualify for if your business is young or hasn't been in the black for long.
- Fixed monthly payments can be a challenge. Because term loans require fixed monthly payments, they may not be as flexible as other types of financing when it comes to managing cash flow. If your sales fluctuate or you have a slow month, you'll still be on the hook for the same payment each month.
- You could be putting your personal assets at risk. Many term loans (secured loans) require collateral, which means you could put your personal assets (like your home or car) on the line if you can't repay the loan.
Where can I get term loans?
There are a number of places you can turn to for term loans, including banks, credit unions, and online lenders.
- Banks. You might be able to get a term loan from your local bank or a national bank like Wells Fargo or Chase. Because they tend to work with businesses that have strong credit scores and histories, it can be tough to qualify for a bank loan if your business is young or hasn't been profitable for long.
- Credit unions. Credit unions are similar to banks, but they're owned by their members (customers). Because of this structure, they may be more willing to work with businesses that don't have perfect credit scores. However, you'll still need to show that your business is profitable and has a solid history.
- Online lenders. Online lenders are a good option for businesses that might not qualify for traditional loans. With an online term loan, you could have looser eligibility requirements, though you may face higher interest rates.
Best alternative to term loans for your business
Term loans often have strict requirements, higher interest rates, and unfavorable repayment terms depending on your situation. They may not be ideal for businesses that have poor credit or need working capital quickly. In fact, the younger you are as a business the less likely you are to be a good fit for a business term loan.
If that’s the case, revenue-based financing might be a better option for your business.
What is revenue-based financing?
Revenue-based financing gives a business money in exchange for a percentage of that business’s future revenue. It’s an option that is becoming more and more popular among start-ups and scale-ips, especially those in the e-commerce and SaaS industries.
The beauty of this funding type is that the repayments are flexible. What you pay back is dependent on your revenue so you only ever pay back what you can afford. It’s also a quick way to finance your business with most loans being approved in a matter of hours or days, not weeks and months.
And unlike term loans, applying for revenue-based financing is frictionless. You won’t need a pitch-deck, to submit a business plan or to provide much paperwork at all. The only thing you really need is a well-documented and flowing revenue history.
You can learn more about the advantages, disadvantages and application process of revenue-based financing here.
Or you can speak directly to a revenue-based financing expert and find out more.