How Lenders Determine Your Business Loan Term and Why It Matters

So you’re getting ready to close on your business loan and finalize all the paperwork to get your funding. Your lender has sent you the details on repayment terms, interest rates, fees, and more, but maybe one or two items have been adjusted since your initial application.

A responsible lender will discuss all of this with you before the closing and has likely had ongoing conversations with you ahead of time to share the “why” behind the changes. One piece that may have been adjusted is your business loan term, or the length of time you’re given to repay your loan.

Your business loan term is an important factor when you’re shopping around for loan options because it impacts whether or not you can afford the debt. A responsible lender will ensure you get a business loan term that’s affordable for you while mitigating the risk they’re taking on, and they may need to make adjustments during the underwriting process to fulfill those goals.

The term varies from loan to loan and is typically determined based on the loan amount and its uses. Let’s take a deeper dive into how lenders determine your business loan term and why this is important to know before you close on a loan.

What’s a business loan term?

As mentioned above, a business loan term is the specific amount of time you’re given to repay the loan. Some loans have shorter terms (like small business lines of credit that need to be repaid within 12 months), and others have long terms (like the SBA 504 loan program that goes up to 25 years).

Taking a look at an example, when you buy a house, you may have the option of getting a 10-year mortgage instead of a 30-year mortgage, which will save on interest and help you own the home faster. Before approving you for the shorter term, your lender will consider whether you have enough cash coming in to make a higher loan payment each month.

Similarly, for a business loan term, commercial lenders will consider whether your business generates enough income to cover the monthly loan payment. Your lender could give you an option for a longer repayment period, or they might determine a shorter term is better for all parties.

Longer terms mean smaller monthly payments while shorter terms call for higher monthly payments. A shorter loan term could work if your business easily generates enough cash flow each month to cover the higher monthly payment. But if that higher monthly payment is close to or more than your monthly cash flow, it can create a financial situation that’s uncomfortably tight.

That’s why, before you sign any closing paperwork, you want to know what the loan term is and that your business’s cash flow can cover it.

Many states have enacted a Truth in Lending Act that requires lenders to give potential borrowers an offer sheet that outlines your loan term, interest rate, fees, and your Annual Percentage Rate (APR). It’s important to review all the information here to confirm that the loan will work for your business now and in the future.

Why would a lender change my business loan term?

When lenders adjust your loan term, it’s usually because they want to lower their risk, better match the term to the loan use, or a combination of both. Here are some examples of why your lender may change your business loan term:

  1. The term length isn’t suitable for the loan use. Let’s say you’re using a loan to buy equipment that you need for your business. As part of the underwriting process, the lender will review data showing the “useful life” of the equipment. If the information shows that the equipment only has a useful life of seven years and you’ve requested a 10-year term, your lender will likely offer something closer to seven years to match the funding to the use.

    When you’re discussing a potential loan with a lender, think about what you’ll be using the money for so you can go into the conversation with realistic expectations about the term length.

    For example, working capital requests that fund staff salaries, inventory, rent, and utility expenses generally have a shorter term (about 3-6 years). As shown in the previous example, equipment purchases have a medium-length term (up to 10 years, depending on the kind of equipment that’s financed). Commercial real estate purchases tend to have the longest terms, going up to 25 years.

    It’s important to understand this when you apply for a loan so that your expectations and the term length that your lender can offer you are more likely to align.
  2. The lender wants to lower their risk by lending for a shorter time period. In this case, your lender has determined that the likelihood of the loan being paid in full is greater if the repayment period is shorter. This is, in part, due to the chance that a longer timeframe means that there’s a longer period over which something could go wrong with the business – and that could jeopardize repayment.

    Let’s say your business is in an industry where historical data shows that the average time a business remains open is seven years. A lender may be less likely to approve a loan for longer than seven years, simply because your business might close after the seven-year mark.

    If you want to know why your lender is offering you a shorter term than you expected, there’s no harm in asking! A responsible lender will be transparent and share their concerns and other factors that resulted in the shorter repayment period.

How your business loan term affects your monthly payment amount

Let’s say you’re applying for a small business loan that can go up to a 10-year loan term. You’ve done the math for your monthly payment over 10 years and know that your business’s cash flow can manage it. However, during the application and approval process, your lender adjusts the repayment term to five years.

The first thing you’ll want to clarify is why your lender changed the business loan term. Make sure you’ve been clear with your lender about how you’ll use the loan. If they think that you’re using it for basic office equipment, but you actually planned to use it for manufacturing equipment, then clarifying this may help you get the longer term.

If, however, there wasn’t a misunderstanding, then you’ll need to ensure that your business can support the higher monthly payment on the loan.

Here’s what that could look like on a loan for $60,000 at 8% interest (with a basic calculation that doesn’t include fees, etc.):

  • With a 10-year term, the monthly payment will be about $728
  • With a five-year term, the monthly payment will increase to about $1,217

If you don’t confirm that your business can cover this higher payment before your closing, it could significantly impact your business’s cash flow and its ability to pay its bills, salaries, and other expenses.

What should you do if your lender offers a shorter business loan term?

If your lender offers you a shortened loan term, the first thing to do is to review your financials to ensure that your business can manage it. It’s likely that your lender will do this before offering you the new terms, but you and your financial team should review your cash flow, too. If you have enough cash flow to manage the higher monthly payment, then you’re all set to move forward with your financing.

However, if you find that your business could be in a financial pinch because of the higher payment, you still have several options:

  1. If there are items or parts of the business that you were going to finance with the loan that you don’t need right away, you could request a lower loan amount to bring the payment back in line with your original budget.
  2. You can review your cash flow to find ways to reduce expenses or find ways to increase profitability. Both tactics are good for strengthening your operations and can help you get the financing you need.
  3. You can shop around for other financing options to see if they can offer you better terms. Sometimes, you may be able to secure a longer term, particularly if a lender has more flexibility.

    For example, if you started with an online lender to get a loan for your business and didn’t get the terms you were hoping for, you could try an alternative lender (like a CDFI) that may offer a longer term and a better APR. If you’re looking for better options, remember that if one seems to good to be true, it likely is. Be sure that any lender you approach is reputable. Otherwise, you could end up with a loan from a predatory lender that puts your business at greater risk for financial distress.

Pursuit makes loans that support small business success

Whether you need working capital, an equipment loan, or you’re buying commercial real estate, Pursuit has a loan program that can support your next step. We offer more than 15 different loan programs for nearly any business need. Our expert team can provide advisory services and financial assistance to small businesses in New York, New Jersey, Pennsylvania, and Connecticut. When you’re ready, contact us to see how we can help you take your business higher!

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