As a small business owner ready to take the next step to grow your company, it can be overwhelming to determine what financing options are available to you. Despite how it may feel, you don’t need to be a finance whiz to secure the best solution for your business. In this brief overview, we’ll outline the basics of one of the most common forms of small business financing: term loans.
What is a term loan?
A term loan is a lump sum borrowed from a lender and paid off at certain intervals over a set period of time. Term loans are typically paid back on a bi-weekly or monthly basis, over a period of one to five years. If you’ve bought a car or a house, you’re probably at least a little familiar with term loans.
How does a term loan work?
The basic mechanics of term loans are simple: Once the application is approved and the offer is agreed upon, the borrower receives the loan, or “principal” amount as a lump sum upfront (minus any fees charged by the lender). The borrower is then responsible for repaying the principal amount in full over the term period, plus interest.
There are two key terms to know that will help you to better understand the cost of a term loan: the interest rate and the annual percentage rate (APR.)
The interest rate is the percentage of the principal amount that the lender charges you to take out the loan. Interest rates can vary from loan to loan, and that variance generally can be understood as a reflection of the loan’s riskiness to the lender. When applying for a loan, the better you are able to demonstrate your ability to repay the loan amount, the better the terms of the loan are likely to be.
Interest rate alone won’t tell you the full story, however. The APR is a more effective tool for getting a holistic view of the loan’s total cost. The APR reveals the bottom line of what the loan will actually cost you each year by tallying up the average of the total interest you will pay, including fees and service charges. It’s an important number to pay attention to when comparing your loan options because, while a loan may appear to have a low interest rate, a high APR will reveal any underlying fees.
Pros and cons of term loans
There are a few primary benefits to term loans:
- Lower interest rates: Term loans are offered at lower interest rates compared to other shorter-term financing options.
- Straightforward budgeting: Term loans are repaid in fixed amounts on a regular basis, so it’s simple to project the required budget for the duration of the loan period.
- Preserves equity: Term loans fall under debt financing rather than equity financing, meaning that it does not involve selling a portion of your business in order to secure funds. This allows you to keep your ownership fully intact.
Term loans have a few different requirements that may not be ideal for all borrowers, including:
- Requires a guarantee: There’s always risk involved in borrowing capital, as most lenders require the borrowers personal guarantee to repay a term loan.
- Requires good credit: Lenders will check both your business and personal financial history and credit score when you apply for a loan.
- Requires demonstrated income: Lenders will also require a demonstrated history of profitability in order to assess your qualifications for a loan—usually around two years worth of financial history.
How to know if a term loan is right for you
Every small business is different, and it’s always important to align the type of financing you apply for to your unique needs.
Term loans usually aren’t the right choice for shorter-term needs, such as a cash shortage or an expense you can pay off fairly immediately. If the need is one that either A) you don’t expect to increase your profitability, or B) can be paid off in the next few months, then a term loan may not be the right choice. In both scenarios, the loan may ultimately be a drain on your cash flow.
The general principle you should have in mind when considering whether or not a term loan is right for you is, “Will the net increase in revenue I expect as a result of this loan outpace the APR I expect to repay over the term period?” In order to assist you in making that projection, lenders require some demonstrated history of income. So, for business owners who are in the earlier stages of growing their business and do not yet have an established record of their finances, a term loan probably won’t be the best fit.
In order to be eligible for a term loan, it’s important to have a clear opportunity in mind—a specific investment that you anticipate will have a direct impact on increased revenue—as well as some visibility into how the funding will grow your business. These specifics will help you to project the cost of an investment, the subsequent revenue you would expect as a result, and over what time period—all important pieces of information to help you to secure a term loan that meets your needs.
Some common use cases for term loans include:
- Opening a new storefront or otherwise expanding your space
- Hiring new employees
- Developing an e-commerce space or revamping your website
- Refinancing high interest debt
- Investing in new equipment or technology that will grow your business