Benefits and Risks of a Business Term Loan
A business term loan can be the perfect answer for financial situations that a business owner may encounter during the course of running a company. It can also help an entrepreneur get finances to start a small business. Yet a business term loan is not a commitment to jump into without a good idea of what it is and what to expect.
Unfortunately, too many business owners run into difficulties after getting approval for a business term loan due to lack of information.
This article will outline the following subjects:
- Business term loan terminology and definitions
- Costs involved in a business term loan
- Benefits and risks
- Where to look
- Getting the most from a business term loan
Business Term Loan Terminology and Definitions
Businesses acquire business term loans for several reasons, ranging from purchasing assets like equipment or vehicles to expanding operations. Therefore, there are several types of these financing options available. The language used for each type is similar, so having an idea what terms mean will be useful, whatever option the business owner chooses.
- Term loan. This means to borrow money for a certain time period. When the loan is paid at the end of the term, the contract ends.
- Long term loan. The most common of the term loans. They are usually approved for larger projects like business acquisition for expansion of established businesses and are repaid each month. Long term loans amounts are higher; the interest rates are lower and established business are more likely to get approval.
- Short-term loans. This business term loan is not repaid with monthly payments. The loan becomes due in full at the end of whatever term is agreed upon. They are often utilized by retailers for small projects and seasonal inventory. Short terms loans are usually under $100,000.
- Assets are items that are owned by a borrower. They may be used as collateral, or guarantee of payment, in a business term loan. Examples of business assets are machinery, buildings, and account receivables.
- Amortization means to reduce the balance of a loan gradually by making payments (usually monthly) that include principal and accrued interest. Home mortgages and other loans are amortized.
- Balloon payment. A type of loan with set payments for a certain length of time and then one large “balloon” payment of the balance when the time expires. For instance, a business long term loan (for 20 years), with a shorter-term balloon repayment after five years.
- Interest structure. There are two basic types of interest structure for most loans like mortgages and business term loans. A fixed rate means that the rate of interest remains the same through the life of the loan and does not fluctuate with current interest rates in the market. Adjusted rates (also called variable rates) are based upon the fluctuating market index rate and can change significantly higher or lower during the loan term.
Costs Involved in a Business Term Loan
There are other costs that come with the approval of a business term loan in addition to the amount borrowed. The business owner will pay interest, which is the cost charged for the loan.
The interest paid depends upon:
- The current interest rate
- The credit score of the borrower (and the amount of other risk the lender calculates)
- Length of the term of the loan
- How the interest is structured (fixed rate or variable)
A business term loan will also incur penalties for payments that are late. The amount for these fees varies by lender. The business owner will also pay a loan origination fee (usually about one percent of the amount of the loan). Closing costs are paid when the loan is approved; they can also vary depending on the lender and the time of loan.
Benefits and Risks
A business term loan is ideal to meet expenses related to high cost purchases which will result in profit over time. Unlike a business credit card, the loan amount will be specific to the purchase and be enough to cover the cost of the intended purchase. Additionally, a business term loan costs less than a business credit card or other financing. Borrowers may also be eligible for tax advantages from a business term loan, depending on the location where they do business.
Risks a business owner assumes with a business loan include:
- The principal and interest payments are mandatory. Nonpayment can result in the loss of assets, including the actual business.
- The indebtedness (or liabilities and accounts payable) of the business is raised as long as there is a balance outstanding.
- Lenders can impose restrictions and limitations which interfere with how the business functions customarily (if this is agreed to in the terms of the contract).
Where to Look
Commercial banks are typically the first place a business owner looks to get a business term loan. These banks are experienced lenders with expertise in financing all types of businesses in addition to funding both new and established companies.
For brand new businesses or a business with bad credit, various financing companies are available to offer creative funding to meet their needs. Brick and mortar lenders, as well as online lenders are other resources for business term loans. Some vehicle and equipment manufacturers have what are called captive finance divisions that finance purchasers of their products.
Getting the Most from a Business Term Loan
To get a business term loan and end up with more headaches than before is counterproductive and costly. The loan transaction can end in a rewarding experience, however, starting with before the loan process starts. This includes the business owner researching in advance to know what to expect and what is expected.
Before applying for a business term loan, the borrower should begin to gather the following documents which the lender will need to process the loan:
- Financial statements (balance sheets, profit and loss statements, etc.)
- A professional and detailed business plan that outlines the use for the loan proceeds and how the business will benefit from the purchase
- Debt schedule
- Personal financial statement of all owners of the business
- Resumes of each business owner
- 3 years of financial projections, including expense expectations
- Tax returns (business and personal) for three years
- Other documentation as requested
While there may be a variation on what each lender expects, these are at least some of the documentation that will be required to process the business term loan. Having them ready can speed up the application process and potentially provide a greater chance for approval.
Advance preparation also includes asking the lender whether all penalties or other costs are included in the terms. There might be additional penalties for early repayment and other fees as well. Information about changing the rate structure during repayment, and if a discount is offered for automatic debit payments should be discussed prior to getting the loan. And business owners can and should have a lawyer or other expert look over the loan terms if they need assistance-before they sign on the dotted line.
A term loan can be a leg up for businesses to accomplish goals that will be financially beneficial to the company. If a business owner is open to flexibility in the amount of the loan, willing to consider alternative means of financing, and committed to making payments on time, the business term loan can make financial dreams a reality.