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Updated: Feb 6, 2020
When you’re shopping around for a small business loan, you may feel puzzled, totally freaked out, or perhaps even eternally doomed.
You may have even considered abandoning your dreams of growing your labor of love to avert the seemingly endless, jargon-infused options that live on the World Wide Web.
But don’t give up just yet. We put together a guide to explain one of the most common forms of small business financing: a term loan.
OK, we know what you’re thinking: another article that promises me the solution to my funding woes, but in reality, reads like a college accounting textbook and leaves me even more confused than before (if that’s possible).
But, we’re asking you to trust us.
Maybe we’re biased, but this guide is useful, and we would even go so far as to say it’s pretty great. So buckle up, here’s what you have to look forward to:
There’s a lot to learn. Let’s dig in, shall we?
A term loan is a lump sum (the “loan amount”) of capital borrowed from a lender and paid off at fixed intervals (weekly, bi-weekly, monthly) over a set period of time (or “term”). Interest rates can be fixed or variable.
If you’ve ever taken out a student loan, mortgage, or an auto loan, you already have some experience with term loans (Disclaimer: Ignore any of your negative associations with the above).
Want to dig deeper into what a term loan is (and isn’t)? Watch the following video. If not, feel free to skip and keep on reading.
There are a number of reasons that term loans are a fan-favorite among business owners.
Offering lower interest rates than credit cards, a term loan makes investments in long-term business growth possible.
But you know what else?
Term loans provides ample time for your investment – such as a new location or upfront purchase of inventory – to begin to make a contribution back to the business before the loan matures.
However, using a term loan to cover a cash shortage when you don’t expect business growth in the near future, or using one to cover an expense you expect to repay in a few weeks, may drag down, rather than boost your business.
This is why analyzing ROI (return on investment) is crucial.
Think about it this way:
If you deploy the funds you raise toward an expense that will generate growth or revenue, the investment will have a positive return on investment.
If you deploy the funds you raise toward an expense that will not generate revenue—such as repainting your office walls—you will have a negative return on investment.
Do you see where we’re going with this?
This is why a term loan is meant to be used for a specific purpose.
Here are a few real-life examples of term loans in action:
Invest in inventory, equipment or a new location: Have you been considering investing in new equipment to boost your business?
Maybe you realized that you can unlock discounts or higher-quality suppliers when you buy raw material in bulk. If you don’t have enough the cash on hand to cover upfront costs (or a down payment on a great space), a term loan could be the answer.
After successfully opening 10 coffee shops using a combination of sales revenue and investments from friends and family, Jonathan Rubinstein of Joe Coffee used a term loan to open his 11th and 12th outposts.
Bring on new hires: Could you use additional staff to prepare for the seasonal uptick in business? Or, have you been putting off making a much-needed hire?
High Tide—a New York-based creative agency behind noteworthy brands like Warby Parker and Casper—utilized a term loan to fill a few roles, including adding an “invaluable” account manager.
Expand your offerings: Do you have an idea for a new product or service that could boost your bottom line?
Minneapolis-based fashion brand Hackwith Design was launched in 2013 with a series of limited-edition pieces released every Monday. Soon enough, the company had expanded to include swim, basics and plus-size in its lineup. When Lisa Hackwith and Erin Husted were gearing up to produce the inaugural bridal line, which “took a lot of upfront investment”, they used a term loan to fill the gap.
Try something new: The beauty of entrepreneurship is the ability to pursue your passion. However, sometimes you may lack excess cash to take advantage of these once-in-a-lifetime opportunities.
Tony Gardner is the founder of Alterian, an effects studio for music, film, and television (he also is behind the creation of those famous Daft Punk helmets). Wanting to try different projects than those supported by paying clients, Gardner used a term loan to branch out and try things that wouldn’t have otherwise been possible (including a recent PSA spot produced with Katy Perry).
Avoid a cash flow crunch: As the saying goes: cash is king.
And when Matt Gallira and Jimmy Warren needed funds to gear up for Big Mozz’s opening season at Smorgasburg, the mozzarella mavens turned to a term loan which “allowed them to breathe”.
Refinance debt: Don’t let expensive credit card debt wear you down.
Bec Brittain—the designer behind premium light sculptures—was charging the costs of materials to her personal credit card, which meant her interest rates were getting out of hand. Worried about the bills and looking to refinance, she applied for a term loan. Now, she is able to focus on what matters most: her craft.
The basic mechanics of term loans are simple: you receive the lump sum upfront (minus any fees charged by the lender). You’re then responsible for repaying the loan amount in full over the period of the term, plus interest.
But, remember: term loans aren’t one-size-fits-all and it’s important to understand what your financing options are.
When choosing the length of a loan, the first thing you should do is calculate how long it will take for the asset being financed to provide a return, and to choose the type of loan accordingly.
Here’s what you’re working with:
But, that’s not all.
There are a few other things to keep in mind when it comes to choosing your terms.
Some things to consider as you weigh your options include:
At this point, you’re likely thinking: “Okay, I get it”.
But you know what else?
Despite a term loan being pretty darn versatile, there are a few instances where it isn’t the best option for your business.
It’s impossible to be everything to everyone.
Here are a few scenarios where an alternative form of financing to a term loan may be a better fit:
By now you’ll have realized whether a term loan will work for your business.
With this in mind, let’s walk through the process of applying (and getting approved) for a term loan—at the best rate. Ready?
Here’s the deal: cost is (obviously) one of the most important considerations when applying for a term loan. At Funding Circle, our interest rates are always the MOST competitive.
So, what’s the bottom line?
As you’re vetting potential lenders, pay close attention to the APR they’re offering. Rates can go as high as 30% for a term loan, and this number directly impacts the cost of borrowing over the long term. If you’re applying for a short-term loan, such as a Merchant Cash Advance, your APR can skyrocket over 100% (Note: some lenders do not quote in terms of APR, so you’ll want to make use of an online APR calculator to evaluate the true cost of the loan).
Once you’ve decided on your potential partners, it’s time to get ready for the application process.
Anyone who needs to gauge how responsible you are financially checks your credit score.
When you’re applying for a term loan, lenders will check both your personal and business credit score (if you aren’t familiar with your business credit, you aren’t alone: more on that here). For personal credit, your FICO and Vantage scores come into play. When it comes to your business credit score, it’s calculated by three companies: Experian, Equifax and Dun & Bradstreet.
The minimum personal and business credit scores you’ll need to qualify for a loan vary from depending on the lender. At Funding Circle, for example, we prefer applicants to have a personal credit score of at least 600.
Before you apply, remember to scan your personal credit report for any inaccuracies that may be hurting your score (the IRS make mistakes too). If you do spot an error, reach out to the credit reporting bureau to have that information corrected or removed. If you aren’t sure how to do that, don’t panic: this handy step-by-step guide can help you figure it out.
While your personal and business credit history is an important factor, it’s not the only thing considered when making approval decisions. Any (or all) of the following come into play:
However, what is required truly varies depending on the lender. So, we’ll answer the following two questions with Funding Circle’s criteria in mind:
Who Qualifies for a Term Loan with Funding Circle?
Requirements vary by lender, but the following are fairly common requirements for a term loan application.
Once you’ve submitted your application, it’s just a matter of time until you receive your offer. And while the journey is almost over, there are still a few things left to discuss (all of which are very important).
Between the fine print and a dizzying amount of financial jargon, we don’t blame you for wanting to blindly sign the contract and be done with it.
And as tempting as it may seem to have the paperwork fade into oblivion and the cash in your hand, putting in the time to understand your term loan offer is a must.
The first thing you want to review is the amount you’re approved for. Be warned: It’s not uncommon for a lender to approve you for a different amount than what you originally requested. And even more importantly: Don’t freak out. Receiving less than you asked for doesn’t mean it’s a bad deal. You just need to understand how the funds you’ve been approved for can impact your business, and whether it makes sense given the total ROI.
It’s important that you hone in on rate—and by rate we mean interest rate, but more importantly, APR—as it reveals how much you’re paying to borrow money.
Paying back a $100k loan over one year is a lot different than paying back a $100k loan over three years. Some institutions allow you to choose from several repayment plans. Perhaps the most important consideration is whether the plan involves paying off your debt in even amounts (allowing you to budget the cost easily) or increasing amounts (allowing you to pay it off more quickly with less interest).
Fees vary by lender, which is why it’s extra important that you review carefully. Here are some fees that may be tacked onto your offer:
If you accept an offer from Funding Circle, we’ll give you the full balance of your term loan minus a 3-5% origination fee (which is the only fee we have).
The remaining piece of the puzzle is determining whether your business is in a position to repay the loan. Analyzing your debt service coverage ratio (DSCR), can provide the answer to this question.
I know what you’re thinking: Ratio? Math? This sounds confusing. We promise, it’s far more simple than it sounds.
DSCR is a ratio that compares the amount of cash a business has available to the debt it has taken on. The calculation below will produce your DSCR ratio.
Interpreting DSCR numbers:
|DSCR < 1||DSCR = 1||DSCR > 1
|A DSCR below one means that you don’t have the ability to pay your debts in full. For example a DSCR of .97 means that you only have the ability to pay 97% of your debt obligations. This means you probably should not be borrowing more money.||A DSCR of one indicates that 100% of your business’s’ net income is going towards paying your debts. While this is sustainable in theory, it leaves you very vulnerable to any variation in your cash flow.||A DSCR above one means that your business is generating enough income to pay its debts. For example, a DSCR of 1.20 means that you are making 20% more income than you need to cover your debts.|
Our suggestion is that you use DSCR to evaluate how much you should realistically be borrowing (which we’ve conveniently included below).
Let’s start with the most important thing: get your credit in order. You don’t need perfect credit to qualify for a term loan but it’s helpful to know where you stand. And, if your score isn’t quite there, you may want to consider holding off on an application. While boosting your credit isn’t exactly fun, it can result in a much more affordable rate.
As Funding Circle’s very own Chris Cap shares, “Oftentimes we speak to applicants who believe our loan will give them the power to grow X%, however without real data, we must temper their expectations given the concrete historical financials we have. If a business has only grown 10% or 20% for the past three years, we will need verification to agree with an owner’s assumptions of 50% growth going forward.” You need to be able to backup your aspirations with factual evidence.
As we mentioned earlier, term loans are meant to serve specific use-cases. However, saying “I want to hire some employees” is not enough. “The more specific the better when detailing your use case, especially for larger dollar loans. We want to see that you put thought into the requested amount and that it is reasonable given your business’s financial state and its goals,” explains Shulman. Taking the time to not only iron out the details of your investment, but the expected ROI on such an asset will help your case.
Samantha Novick is a senior editor at Funding Circle, specializing in small business financing. She has a bachelor's degree from the Gallatin School of Individualized Study at New York University. Prior to Funding Circle, Samantha was a community manager at Marcus by Goldman Sachs. Her work has been featured in a number of top small business resource sites and publications.