Business Term Loan

A business term loan is credit advanced to a business as a single sum, repaid over a defined term on an agreed schedule of payments. It has three defining features: the whole amount is disbursed at the start, the maturity date is fixed when the loan is made, and repayment follows an amortization schedule in which each installment covers the interest accrued and reduces the principal. "Term loan" is descriptive industry usage rather than a defined regulatory category, and the word doing the work in it is "term": the loan has an end date, agreed in advance, by which it will have been paid off. That is what separates it from a business line of credit, which has a limit rather than a balance and can be drawn, repaid and drawn again.

The structure suits a cost the business can size in advance. Buying a piece of equipment, fitting out a second location, acquiring a competitor, refinancing more expensive debt: each is a known amount on a known date, and the business can weigh the fixed monthly payment against the cash the investment is expected to produce. The structure suits a fluctuating need badly. A business whose problem is that receivables arrive three weeks after payroll does not have a one-time gap; it has a recurring one, and borrowing a lump sum to cover it means paying interest on the full amount in the weeks when it is not needed. That is the case a revolving facility is built for, and our business line of credit page covers how those work.

Maturity is usually matched to the useful life of whatever is being financed, for a reason a borrower can use as a sanity check: a loan that outlives the asset leaves the business paying for something it no longer has. The only place that principle is written down as a rule is the SBA's, and it is worth reading even for a borrower who will never use an SBA loan. The regulation directs that the term of a loan be "the shortest appropriate term, depending upon the Borrower's ability to repay"; ten years or less "unless it finances or refinances real estate or equipment with a useful life exceeding ten years"; and a maximum of 25 years including extensions, with the longer figure available for real property. Conventional bank lending is not bound by any of that, but it tends to land in the same places, and a lender offering a term noticeably longer than the life of the asset is usually pricing something else into the deal.

What secures the loan shapes both the rate and the consequences of default. Equipment, vehicles and real property can serve as collateral; a business with none of those may be offered an unsecured loan at a higher rate, or a smaller one, or none. Separately from collateral, most small business term loans carry a personal guarantee from the owners, which is a promise rather than a lien and reaches the owners' own assets. For SBA-guaranteed loans that is close to automatic: the loan conditions provide that holders of at least a 20 percent ownership interest generally must guarantee the loan. Collateral and a guarantee are not alternatives, and a lender that takes both is taking two different kinds of security.

The loan agreement will usually carry covenants, which are promises about how the business will be run while the debt is outstanding: maintaining a minimum ratio of cash flow to debt service, capping additional borrowing, providing financial statements on a schedule. Breaching one is an event of default even where every payment has been made on time, which surprises borrowers who equate default with missed payments. Prepayment deserves the same attention before signing rather than after. Some term loans can be paid off early with nothing more owed than the interest accrued to that date; others carry a prepayment penalty, or are quoted as a fixed total repayment amount so that paying early saves nothing at all. The difference does not show up in the monthly payment, and it decides whether refinancing later is an option or an expense.

1. The business applies for a stated amount and the lender underwrites it against the business's cash flow, its history, any collateral, and usually the owners' credit.

2. The loan closes and the full sum is advanced, once. There is no undrawn balance to come back to later.

3. Repayment follows an amortization schedule. Each installment covers the interest accrued since the last one and applies the rest to principal, so the interest portion shrinks as the balance does.

4. The rate is fixed or variable. A fixed rate keeps the payment constant; a variable rate moves the payment, or the term, with the index it is tied to.

5. The loan ends at maturity, with the balance at zero if the schedule was followed, or with a balloon payment if the schedule was written to leave one.

An example of the arithmetic. A landscaping business borrows $120,000 over seven years at 9 percent to buy two trucks and a trailer. The monthly payment is $1,930.69. In the first month, interest is $120,000 × 9% ÷ 12 = $900, so only $1,930.69 − $900 = $1,030.69 goes to principal. Over the full 84 payments the business pays $1,930.69 × 84 = $162,177.91, of which $42,177.91 is interest. The figure worth noting is the first one: in month one, 47 percent of the payment is the cost of carrying the debt rather than reducing it, which is why a business that expects to sell the trucks in three years should ask what the payoff balance will be at that point rather than assuming it will be three-sevenths repaid.

Pros

• The cost is knowable in advance. With a fixed rate, the business knows the payment, the term and the total interest before it signs.
• Repaying on a schedule builds a documented history with the lender, which is what makes the next loan easier.
• Matching the term to the asset spreads a large cost across the period the asset is earning, rather than draining cash in one quarter.
• Rates are generally lower than on revolving or sales-based alternatives, because the lender's exposure declines on a known schedule.

Cons

• The money is drawn once. A business that repays and needs to borrow again starts a new application.
• Interest runs on the full balance from day one, including on any portion the business has not yet spent.
• Covenants can put the loan in default while every payment is current, for example by breaching a financial ratio or missing a reporting deadline.
• Prepaying is not always free. A penalty, or a loan quoted as a fixed total repayment, can make early payoff worthless.
• Most come with a personal guarantee, so the owner's own assets stand behind a business obligation.