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Funding 101: Everything you need to know about business term loans

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Funding 101: Everything you need to know about business term loans

Updated: July 17th, 2024

A plant growing - Funding 101: Everything you need to know about business term loans

Among the countless financing options available for small business owners, a business term loan is one of the best. You can use business term loans at almost any stage of your business’s growth, whether you want to build up your customer base, expand operations, or explore new projects. 

Not all business term loans are alike, though. To help you figure out whether or not a term loan is right for you, we’re breaking down everything you need to know. 

There’s a lot to learn. Let’s dig in, shall we?

What is a business term loan?

A business term loan is a lump sum of money you borrow from a lender, then pay back at fixed intervals — with interest — over a set period of time. Depending on your lender, you’ll pay off the loan on a weekly, bi-weekly, or monthly basis. Repayment periods can last from a few months up to 10 years or more. 

Interest rates also vary by lender, but they can be either fixed or variable. Fixed rates stay the same, while variable rates change depending on the state of the market.

Why term loans?

There are a number of reasons term loans are a fan favorite among business owners. Here are just a few:

  1. Lower interest rates: Due to their longer durations, business term loans are typically available at lower interest rates than short-term business loans.
  2. Cash flow flexibility: Term loans can help free up your cash flow. When you get funding for big investments or purchases from a term loan, you can allocate your remaining cash for short-term operational expenses and emergencies.
  3. Set payment structure: Business term loans give you more than just funding — they can also bring peace of mind. With a term loan, you have a predictable repayment schedule, which means you can plan and budget more easily.
  4. Simple, streamlined application process: Applying for an online term loan is fast and straightforward. You can fill out an application in minutes from the comfort of your couch, and usually hear back within a few days. 
  5. Business advantages: The interest on a term loan is tax deductible, so you can save some money come tax season. Plus, making repayments on time can boost your business credit score, helping you score future financing opportunities at lower interest rates.

Autonomy: Since a term loan is a form of debt financing, you aren’t sacrificing equity for capital. Your business’s ownership stays 100% with you.

What can you use a term loan for?

Business term loans are great vehicles to invest in big purchases and long-term business growth. With long repayment periods and typically lower interest rates than credit cards, term loans give you ample time to generate a return on your investment before you have to pay your loan off. 

You can use a term loan to: 

  • Open a second location
  • Expand or remodel your property
  • Hire more employees
  • Buy a new building or space
  • Purchase equipment, machinery, or software
  • Cover upfront project or inventory costs
  • Refinance debt

Term loan examples

Here are a few real-life examples of term loans in action:Expanding business: Arianna Parsons and Tyrell Thacker, co-owners of Beck’s Coffee in Las Cruces, New Mexico, used a term loan to open a second location

Covering inventory costs: Jan Hogrewe of Just Jan’s got a term loan to pay for inventory and production expenses

Freeing up cash flow: Michael Parnell of MP Consulting Services used a term loan to free up his cash flow, so he could make decisions based on strategy — not fear of failure. 

Developing a new product: Jim Malone used a term loan to fund his new product lines for his sustainable furniture company, CounterEv. 

Buying a second business: When Brian Bradley wanted to expand his paintball store, he used a term loan to buy a complementary business: an indoor paintball field.  

Marketing: Willie Powells used a term loan to market his growing law practice and get ahead of the local competition.

How do business term loans work?

The basic mechanics of term loans are simple. Once you qualify, you receive the entire loan amount upfront (minus any fees charged by the lender). Then, you’re responsible for repaying the loan amount in full over the period of the term, plus interest.

Types of business term loans

There are three main categories of term loans

  1. Short-term business loans typically have repayment periods of one year, which means you generally have to make daily payments. These term loans are usually easier to qualify for, but they tend to have higher interest rates as a result. That’s why it’s important to use short-term loans only for expenses that will deliver an immediate payoff. Think: ordering extra inventory to meet seasonal demand or buying a new delivery vehicle. Otherwise, you could fall behind on your payments and rack up a lot of debt in interest fees. 
  2. Intermediate term loans generally have repayment periods of one to five years, with regular payments occurring on a bi-weekly or monthly basis. They’re helpful for opening a new location, expanding your team, purchasing equipment or inventory, and refinancing debt. If, for example, you use an intermediate term loan to hire a new salesperson, the loan can help fund the time it takes for the employee to go through training and begin to bring in revenue. 
  3. Long-term business loans generally run from six to 20 years. Long-term loans are ideal for undertaking large construction projects and purchasing equipment, buildings, or other businesses. Though long-term loans tend to offer lower interest rates, they’re also harder to qualify for. Lenders typically only extend long-term business loans to established business owners who have proof of revenue and great credit. 

Features of term loans: Other considerations

Here are a few other factors to consider when deciding on a term loan:

  • Secured vs. unsecured term loans: Secured loans require you to put up collateral or provide a personal guarantee to your lender. That means that if you can’t pay back your business loan for any reason, your personal assets — like your car or house — will be on the line as payment. Unsecured loans don’t require collateral or personal guarantees, but that means they’re riskier for lenders. As a result, unsecured loans typically have higher costs and shorter repayment terms for the borrower. Short-term loans are usually unsecured, while long-term loans generally require collateral. 
  • Fixed vs. variable interest rates: A fixed interest rate doesn’t change once a lender sets it, but a variable rate can increase or decrease over time. Variable interest rates are tied to an index or benchmark rate, such as the prime rate. The primary benefit of choosing a fixed interest rate is predictability; there’s no guesswork when it comes to your payments. Variable rate loans, on the other hand, are more of a risk. The appeal of variable rate loans is that they tend to have a lower starting point than their fixed rate counterparts; if there’s no significant change in the prime rate, you may pay less in interest than you would if you opted for a fixed rate. However, there’s always the possibility that your payment could substantially increase if your rate increases. 

Fees: Your term loan could come with a handful of different fees, including origination fees, late payment penalties, monthly or annual loan fees, and prepayment penalties (more on these later). Unless the fees are separate from your loan payments, you’ll end up paying interest on your loan and the various fees, which can mean spending more over time. 

How to decide if a term loan is right for you

Consider the following questions before you make a move:

  • What do I need funding for? If you need money for a costly purchase or growth project with big ROI potential, a term loan could help. However, if you need to cover ongoing operational expenses or pay for a small expense, you may want to consider another type of financing, like a line of credit
  • What’s the payoff? It’s best to use a term loan for a purchase or project that can help you generate more revenue or reach new customers. Crunch some numbers to estimate the potential return on your investment.  
  • What do my business finances look like? In other words, will you be able to pay back your loan amount on time and in full? If your business is already in the red financially, getting a term loan could set you back further. 

When not to use a term loan

Though term loans stand out for their affordability and versatility, they’re not always the best solution for every business. Here are a few scenarios where a term loan may not work as well as another type of financing:

  • If you’re a startup or new business: A term loan should enhance business operations without placing undue pressure on cash flow. If you haven’t been in business for at least a year and generated significant revenue, a term loan may not be for you. Part of the reason is because you may not qualify. A key component of a lender’s underwriting process is analyzing a business’s financials to verify that the cash a business brings in will be able to support the loan payments. However, without access to financial records over a meaningful period of time — usually one to two years — lenders won’t be as confident in your ability to manage and guide your business’s growth. 
  • If you have poor credit: When you apply for a term loan with average credit, you could face high interest rates — if you qualify at all. That’s because lenders use both your personal and business credit scores to determine how risky you are as a borrower. 

If you’re not certain about your ROI potential: Term loans aren’t the best options for short-term funding needs and investments with minimal ROI potential. If you use a term loan to cover a temporary cash crunch or pay for a project that won’t contribute to your revenue, the loan could end up dragging you down.

How to prepare for a term loan

If you’re ready to apply for a term loan, take the following steps to prepare: 

1. Research lenders

Start by researching potential lenders. While banks offer lower interest rates, the application and approval processes can be tedious and lengthy. Online lenders, on the other hand, have slightly higher interest rates, but they typically make up for it in ease of application and speed of approval.  

2. Get your business and personal credit scores in check

When you’re applying for a term loan, lenders will check both your personal and business credit scores. For personal credit, your FICO and Vantage scores come into play. Your business credit score is the result of calculations from three companies: Experian, Equifax, and Dun & Bradstreet.

The minimum personal and business credit scores you need to qualify for a term loan vary from lender to lender. At Funding Circle, we prefer applicants to have a personal credit score of at least 660.

Before you apply, scan your personal credit report for any inaccuracies that may be hurting your score. If you spot an error, reach out to the credit reporting bureau so they can correct or remove that information. 

3. Review the lender’s minimum requirements

Your credit history is an important component of your loan application, but there are other factors that come into play, including:

  • Your personal and business cash flow
  • Your personal and business assets
  • How long you’ve been in business
  • Your annual business revenue
  • Your business plan

Who qualifies for a term loan with Funding Circle?

To get a term loan with Funding Circle, we require:

  • At least two years of operating history
  • A personal FICO score of at least 660 for business owners
  • Proof of profitability (or a positive net income)

4. Gather your documents

Regardless of your lender, it’s helpful to have the following items on hand when applying for a term loan

  • Employer identification number (EIN): A lender uses your EIN to request your tax return transcripts directly from the IRS.
  • A few years of business tax returns: Your tax returns show how you manage your finances. Lenders often require both your personal and business tax returns.
  • Balance sheet and income statement: Your balance sheet and income statement paint a more complete picture of your business’s financial health, showing your expenses and profit and loss history. 
  • Bank statements: Your bank statements give lenders insight into how well you manage the cash coming into your business, and whether or not you’ll have the funds to pay back your loan.
  • Debt schedule: A debt schedule outlines your debt obligations, including (but not limited to) loans, leases, contracts, and notes payable. This helps a lender determine whether or not you can handle taking on new debt. 
  • Business plan: Your business plan gives lenders a better idea of your short and long-term business goals, your business’s history and accomplishments, and the market potential for your services or products.

Statement of funding needs: In the financial section of your business plan, make sure you spell out exactly how much funding you need, what you plan to use it for, and how that investment will help grow your business. It’s crucial to be specific. Instead of saying, “I want to hire more employees,” for example, explain that you need to hire two new salespeople to bring in 10% more annual revenue. 

How to evaluate your term loan offer

Once you qualify for a term loan, it’s time to examine the fine print. Reviewing your term loan offer can help you avoid setbacks and make the most of your finances. Take the time to assess the following:

  • Term loan amount: The first factor to review is the amount you’re approved for. Keep in mind that a lender may approve you for a different amount than what you requested — but receiving less than you asked for doesn’t mean you’re getting a bad deal. You just need to consider how that particular amount of funding can impact your business, and whether or not it makes sense given the total ROI.
  • Rate: The interest rate on a loan represents the current rate of borrowing, while the annual percentage rate (APR) is the total annual cost of a loan, including all interest payments, fees, and services charges. The APR reflects the true cost of the term loan, so it’s important to know what yours is.
  • Repayment terms (duration): Consider how realistic your repayment term is. Paying back a $100,000 loan over one year is much more challenging than paying back a $100,000 loan over three years. Some institutions let you choose from several repayment plans, including paying off your debt in even amounts (which allows you to budget the cost easily) or increasing amounts (which allows you to pay it off faster and accrue less interest).
  • Personal Guarantee: Lenders often require personal guarantees when granting loans to small business owners. If that’s the case, you’ll assume personal liability for your business’s debt, which means your lender will be able to seek legal recourse against you if your business defaults on the loan.
  • Fees: Fees vary greatly by lender, so it’s critical to review them carefully. Here are some fees that may be tacked onto your offer:
    • Origination fee: Like a commission, this is an upfront fee the lender charges to process a new loan. 
    • Processing fee: This is a catch-all term for the miscellaneous costs of underwriting a loan that lenders sometimes pass on to the borrower.
    • Utilization fee: A lender bases this annual fee on the amount of credit actually used by a borrower (in instances where the loan is drawn down in smaller advances).
    • Documentation fee: Some banks charge a documentation fee (in the $100-200 range) for filing a loan application.
    • Prepayment penalty: Some lenders charge a penalty if you pay off your loan ahead of schedule.
    • Late fee: You could be charged a late fee if you don’t make payments on time. 
    • Broker’s fee: If you hire a broker to help facilitate your loan, you’ll have to pay a fee, usually between 1-3%. 
    • Commitment fee: Some lenders charge this fee for guaranteeing a loan in the future. It’s usually a fixed percentage of an undisbursed loan amount. 
    • Closing fee: These are the costs of the lender’s lien on loan collateral. Most institutional term loans don’t require closing fees.

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).

How much can your business afford?

The last piece of the puzzle is figuring out whether or not your business is in a position to repay the loan. Analyzing your debt service coverage ratio (DSCR) can help.

DSCR is a ratio that compares the amount of cash a business has available to the debt it has taken on. Here’s a formula you can use to calculate your DSCR ratio:

DSCR = Net Operating Income / Debt Service

As an example, if your business has a net operating income of $200,000 and a total debt service of $120,000, your DSCR would be 1.6.

DSCR < 1
DSCR = 1
DSCR > 1
A DSCR below one means you don’t have the ability to pay your debts in full. For example, a DSCR of 0.97 means that you only have the ability to pay 97% of your debt obligations. This means you probably shouldn’t borrow more money.A DSCR of one indicates that 100% of your business’s net income is going toward paying your debts. While this is sustainable in theory, it leaves you vulnerable to any variation in your cash flow.AA DSCR above one means your business is generating enough income to pay its debts. For example, a DSCR of 1.20 means you’re making 20% more income than you need to cover your debts.


The views and opinions expressed in this article are solely those of the author writing in her individual capacity. They do not purport to reflect the views or opinions of Funding Circle.

This content is for educational and information purposes only, and should not be taken as financial, tax, legal or HR advice. It is not intended as a substitute for professional advice
.

Original version by Samantha Novick, updated by Paige Smith

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