When it comes to financing for your small business, term loans are the most common form of funding. Here, you’ll learn what a term loan is, how to calculate its cost over time, and more.
What is a business term loan?
A business term loan is perhaps the most traditional method of small business financing for borrowers in need of financing for longer than 12 months. Term loans for businesses can vary widely but they all have a few things in common. The borrower receives a lump sum payment from a lender, which is paid back at certain intervals over a fixed period of time. The financing arrangement is classified as a business loan on the balance sheet of the borrower.
Business term loans are used for a wide variety of reasons. Generally speaking, business term loans are used to make longer-term investments in your business, including the purchase of fixed assets, investment in new technology, and hiring staff. The best practice is to match the maturity of a term loan with the useful life of the asset being financed. For example, it is recommended you obtain a 10-year term loan to purchase a new piece of equipment with a useful life of at least 10 years.
Business term loans vary in:
- Interest rate – Typically variable (can fluctuate over time) or fixed (primarily for real estate)
- Length of time to repay – Short term: 1-3 years; Intermediate term: 3 – 5 years, Long term: 5+ years
- Repayment intervals – Typically monthly
- Types of Fees/Penalties
- Origination fee: Ranging from 1 – 5% of the loan amount to cover lender’s underwriting costs
- Closing fees: Ranging from 0 – 1% of the loan to cover third party expense related to closing the loan
- Prepayment penalties: Ranging from 0 – 2% for repaying balance prior to end of loan term
- Late fees: Ranging from 3 – 6% on the amount that is overdue
- Collateral – Typically secured by business assets, and often times personal assets
Why use business term loans?
Businesses tend to prefer term loans because repayment amounts are fixed, so you know what is due every month, and payment amounts tend to be lower because repayment is spread out over a longer period of time.
Again, businesses use term loans to obtain longer-term funding for the purchase of long term assets. Be aware that a term loan is not the best way to cover short term/temporary financing needs such as working capital if there is a prepayment penalty.
Business term loans tend to carry a higher risk of nonpayment because repayment takes place over a longer period of time. Therefore, bank term loan lenders typically have higher requirements for (1) minimum years in business, (2) minimum annual revenues, (3) minimum cash flow coverage of debt service, and (4) collateral. The application is usually more detailed and the approval process is longer. As a result, the rate of approval for small businesses is not as high compared to other financing options.
Typically, start-up companies will not qualify for bank term loan financing. As a small business owner, you should know upfront about the lender’s requirements for approval before you apply. If approved, however, your interest rate can be significantly lower than some of the high cost, short term alternatives!
How do I calculate the true cost of a business term loan?
The true cost of a business term loan includes both the stated interest rate you pay plus all costs/fees you incur in obtaining the loan. In order to accurately compare loan options, you need to calculate the annual percentage rate (“APR”). To calculate the true cost of a term loan, you need to have the following information:
Loan Amount: The lump sum borrowed
Example: $50,000 Loan Amount
Interest rate: The percentage rate (%) paid on the amount you borrowed
Example: 12%, Variable rate based on the published Prime Rate
Origination Fee: The percentage (%) of Loan Amount you are charged upfront to process your loan.
Example: $50,000 Loan x 3% = $1,500 Origination Fee
Repayment Term: The length of time from when a loan is disbursed until the loan is paid back in full.
Example: 60 months (5 years)
Repayment Amount/Frequency: Fixed monthly payments
Example: $1,112 per month
Using this information in a loan calculator, you can calculate the true cost of your term loan. Your annual interest rate is stated as 10%. However, when you include fees, the calculated APR is actually 13.35%. Make sure to use this APR when comparing the different loan options available to you.
What are the alternatives to business term loans offered by banks?
Small business owners who are in need of longer term funding, but do not yet qualify for traditional bank term loans may be eligible for financing from community lenders, such as Community Development Financial Institutions (“CDFIs”).
CDFIs are primarily non-profit organizations that have access to lower cost community and economic development loan funds to provide smaller dollar loans to business owners who do not meet conventional banking criteria. Many CDFIs offer micro-loans, which are smaller dollar term loans with a different set of eligibility requirements than a bank term loan. Some CDFI term loan products feature an online loan application with a 24-48 hour approval process. There are also “Community Advantage” lenders that offer SBA term loans up to $250,000.
The U.S. SBA is the largest funding source for small businesses in the United States. SBA lenders offer business term loans for equipment, machinery, and real estate at competitive rates.
Conclusion
If you are a small business owner in need of long term financing but do not qualify for traditional banking products, explore alternative financing options available through your local CDFI.
