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The Pros and Cons of a Term Loan

Jamie Johnson
Jamie Johnson

Terms loans can be a great option for financing growth initiatives for your business.

  • With term loans, you receive a one-time lump sum of money.
  • These loans can be used for personal and business expenses.
  • Term loans are an excellent option for both short- and long-term financing needs.
  • This article is for business owners looking to learn whether term loans are the right financing option for their business.

As a business owner, you know how important it is to invest in new growth opportunities. But you don't always have the cash on hand to make these investments. In this scenario, small business financing can be a lifesaver.

If you're looking for financing, you've probably considered taking out a term loan. Before committing to this type of loan, though, it is important to understand what it is and how it differs from other options out there.

What is a term loan?

If you've ever taken out a mortgage or personal loan, then you're already familiar with how a term loan works. It is a one-time upfront payment you receive from a bank, credit union or online lender.

The lender provides the funds, and you repay the loan with interest over a period of months or years. The interest rate can be fixed or variable and tends to be lower than the rates for other types of financing.

Term loans can be used for both personal and business expenses. Many business owners apply for a term loan to fund a one-time project or as a means to achieve long-term business growth. [In need of a small business lender? Check out what we recommend as the best loan options for small businesses.]

How do term loans work?

You apply for a term loan through a bank, credit union or online lender. Banks and credit unions tend to offer the most favorable rates, but they have more stringent requirements and can be harder to qualify for.

In comparison, an online lender may have higher rates, but the application process is more straightforward, and you'll often receive faster approval and funding. And if you choose to apply through a lending marketplace, you'll submit your application just once and receive offers from multiple lenders.

TipTip: When choosing a lender, consider how quickly you need the money. If you need it fast, an online lender that offers same-day funding may be your best option. However, be prepared to pay higher rates than you would by going through a traditional bank.

Once you've chosen a business lender and been approved for the loan, you must agree to the rates and repayment terms. The rates you'll receive depend on various factors, including your personal and business credit history, cash flow, and time in business.

The repayment terms for a business loan typically range from three to 10 years. If you receive a fixed-rate loan, your interest rate will stay the same over the life of the loan. With a variable-interest loan, your rate will change periodically.

 

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What is a term loan example?

There are two general types of term loans: short-term and long-term loans. The type of loan you apply for will depend on the business you run and your financing needs.

A Small Business Administration (SBA) loan is a good example of a term loan. If you apply for a standard 7(a) loan from the SBA, you could receive up to $5 million in funding. Your lender will determine your rates, but they cannot exceed the SBA's maximum.

Of course, not all businesses need that kind of financing, so the SBA also offers 7(a) small loans. These loans top out at $350,000. SBA loans always have fixed rates and a set repayment period.

You can use the funds from a term loan to expand your business operations, purchase equipment, or finance a new marketing campaign. Term loans allow companies short on cash flow to invest in new opportunities and maximize their chances for additional revenue.

What are the benefits and drawbacks of term loans?

Like all financing options, term loans have both pros and cons that you must consider before deciding on a course of action.

Pros

  • They can fund short-term financing needs. If you need to purchase new assets or equipment for your business, a term loan can be a good option. You can take advantage of the opportunity to grow your operations, and the revenue you earn will help you pay back the loan.
  • They tend to have lower rates. Term loans generally offer low rates and flexible repayment terms. You can repay the loan over the time you need without it becoming too much of a financial burden for your business.

Cons

  • They're relatively hard to qualify for. Since term loans have favorable rates and repayment terms, they are usually harder to qualify for than other loans. You need to show excellent credit history and provide detailed financial information to your lender.
  • Some lenders will require collateral. If your lender considers your business a financial risk, they may require you to put down some type of collateral. This is known as a secured loan, and if you can't repay it, your personal or business assets are at risk.
  • They may charge additional fees. Some lenders charge additional costs for term loans, such as origination fees. Depending on the lender, you could even get hit with a prepayment penalty if you pay off the loan ahead of schedule.

Did you know?Did you know? The interest rate isn't the only fee you may be charged for a loan. Origination, processing and prepayment fees are all possible charges that you must factor into the total cost of a loan.

Types of term loans

If you decide you want a term loan, you can apply for a short-term, intermediate-term or long-term loan.

Short-term loans

These are loans you can take out for smaller amounts, with shorter repayment periods – generally one or two years.

Short-term loans are good for day-to-day working capital expenses. However, since these loans are more convenient and easier to apply for, you can expect to pay higher rates.

Intermediate-term loans

Intermediate-term loans are the happy medium between short- and long-term loans. The repayment terms are typically two to five years, and you can access up to $500,000.

These loans are a good option for businesses looking to open a new location or hire more people. This type of funding can help you expand your business operations and begin generating more revenue.

Long-term loans

Long-term loans offer the highest amounts and the longest repayment terms. You can access millions of dollars in funding, and the repayment terms can be up to 25 years.

A long-term loan is a good option for an established business with excellent credit and a solid financial record. You may consider one to fund long-term growth strategies for your business.

Key TakeawayKey takeaway: There are short-, intermediate- and long-term loans. Each type varies in how much money you can obtain and how long you have to pay it back.

When to consider a term loan

If you're considering small business financing, you have many options to consider. So how do you know if a term loan is the right choice for your business as opposed to, say, a revolving line of credit?

In general, a term loan is a good choice for a short-term project or expense. For instance, if you need to purchase inventory or invest in a marketing campaign, a term loan can help you cover this expense.

Term loans are best for established businesses with proven financial track records. If you have poor credit or limited business experience, qualifying for a term loan may be too difficult.

Finally, term loans are best for businesses that don't need the money immediately. Applying for a term loan can take time, especially if you want to take advantage of the low rates at a bank or credit union. So, if you need fast access to cash, a term loan may not be your best option.

How to apply for a term loan

 Here are the steps you'll need to take when applying for a term loan:

1. Get your paperwork in order.

It's a good idea to get your financial records in order before you apply for the loan. The exact requirements vary by lender, but here's an overview of the information you can expect to provide:

2. Apply with multiple lenders.

When you're applying for a term loan, the total cost of the loan should always be top of mind. If the interest rates are excessively high and you don't generate a lot of additional revenue from your investment, you could find yourself upside down on the loan. It's a good idea to apply with several lenders so you can compare the rates and repayment terms to find the most affordable loan for your business.

Many lenders will preapprove you for a loan with just a soft credit inquiry, so you don't have to worry about it hurting your credit score. You can also apply through a lending marketplace and receive multiple offers with just one application.

3. Compare your offers.

Once you've received offers from several lenders, evaluate each one. It may be tempting to go with the lender that offers you the highest loan amount, but you should consider a few other things.

Pay close attention to the annual percentage rate (APR), which will help you determine how much it will cost you to borrow the money. You also want to look at the repayment terms, as this will significantly impact your ability to repay the loan.

It is also important to pay close attention to any fees that the lender charges. If the loan has a low rate and flexible repayment terms, it's easy to overlook the fees, but they can add thousands of dollars to the cost over the life of the loan. Here are some significant fees to look out for:

  • Origination fees: An origination fee is what you'll pay the lender upfront to process the loan. These fees range from 1% to 5% of the total loan amount.
  • Prepayment penalty: If you pay off the loan early, the lender loses out on future interest payments, so some lenders charge a penalty fee for this.
  • Late fee: As with most monthly costs, you'll pay an additional fee for making your monthly payment late.
  • Processing fee: A processing fee covers the cost of underwriting the loan.

4. Close on the loan.

Once you've chosen a lender and agreed to the terms, you're ready to close on the loan and receive the funds. Depending on the lender, you could receive the funds within a day or two of the closing.

Image Credit: Witthaya Prasongsin / Getty Images
Jamie Johnson
Jamie Johnson
Business News Daily Contributing Writer
Jamie Johnson is a Kansas City-based freelance writer who writes about finance and business. She has also written for the U.S. Chamber of Commerce, Fox Business and Business Insider. Jamie has written about a variety of B2B topics like finance, business funding options and accounting. She also writes about how businesses can grow through effective social media and email marketing strategies.