Term Loan Definition: A Complete Guide on Understanding the Different Types of Term Loans
According to statistics, eight out of every ten new businesses will fail within their first 18 months.
Furthermore, the Small Business Administration estimates that only one-third of new businesses can survive for the first ten years. A critical reason for these businesses failing is the lack of adequate capital to keep the company running or grow it.
Thus, you as the entrepreneur need to be aware of the various forms of funding available in the market. Term loans are a source of capital that can help your firm weather any storm and grow. Keep reading to understand the proper term loan definition and the various kinds available to you.
Term Loan Definition
A term loan is a lump sum from a lender that a borrower receives for a specific amount and for which the borrower pays back through a specified repayment schedule. The interest charged on a term loan can either be a floating or fixed one.
How Term Loans Work
Once you take out a term loan, each payment you make goes to cover the interest and a portion of the principal amount.
A term loan also comes with predetermined fees that you must honor. You can choose to either pay these fees upfront or add them to your total loan balance. Be sure to consult with your lender during the application process for the loan to find out the best way for you to handle the fees.
A critical requirement the lender will ask of you when you take out a term loan is that you secure insurance on the collateral.
Should you then be unable to keep up with the insurance payments (or even taxes) on the assets, the lender can advance you more money as a way of protecting the collateral. The downside is that your lender will then add such advances onto your loan, and charge you additional interest.
Since the repayment schedule for a term loan requires you to make each payment on a specific date, any delay will earn you a penalty. Traditionally, repayments happen every month, but some lenders can give you the option of paying quarterly.
In some exceptional cases where a lender gives you a term loan for an extended period, they can ask for a short term repayment schedule. For example, a lender giving you a 25-year term loan might decide to structure your repayment schedule over five years.
During the five years, you will be repaying the interest in full. Once the period expires, you will then have to repay the principal amount in full (known as a balloon payment).
Types of Term Loans
Generally speaking, term loans can fall into two broad categories, i.e., secured and unsecured.
Unsecured term loans are those which you do not need any collateral to get them. On the other hand, secured term loans are those which the lender will require you to put down an asset as a pledge against the funds you receive.
Aside from broad classifications, depending on whether you pledge any assets for a term loan, you can also classify them according to the term.
1. Short Term Loans
As the name implies, a short term loan is for a brief period, which typically is between 1 to 2 years.
The best time to consider a short term loan is if you need liquidity for day to day operations. For example, if you need to shore up your working capital, then a short term loan is what you need. You can think about getting a short term loan if you expect to grow your business soon and require a boost to do it.
Due to their brief shelf life, short term loans carry higher interest than long term loans. What you need to factor in here is that the easier it is to get the loan and the shorter the term, then the higher the interest rates.
In addition, it is not uncommon to find that the charges you receive when you default are also higher. Thus, it would be best if you weighed how you expect to generate new income against the requirements of a short term loan.
You can get a short term loan from a commercial bank and trade credit sources, among others.
2. Medium Term Loans
Medium term loans last between 2 to 5 years. You can think of these kinds of loans as a cross between long and short term ones.
You can get up to $500,000 with a medium term loan. A medium term loan is best if you have an already existing business and need more funding to expand it. For example, you should acquire a medium term loan if you want to hire new workers or open another location.
To get a medium term loan, you need to have adequate credit. Additionally, your business needs not only to be generating revenue but also making a profit. Normally, lenders will consider giving your business a medium term loan if it has been operational for one year or more. Aside from these core qualifications, each lender will set other requirements as they see fit.
3. Long Term Loans
A long term loan is one that you can repay with a schedule anywhere between 3 and 25 years. Through these loans, you can get anywhere from several thousand dollars to millions of dollars.
The essential feature of long term loans is how affordable they are. You are likely to get the most affordable interest rates when you apply for a long term loan. Securing such a loan through a bank only helps make interest rates even more affordable.
A long term loan works best for an established business that has a strong financial track record. You should get a long term loan if you are looking to invest in a long term strategy that can grow your business. For example, if you need to buy real estate or set up another warehouse, then such a loan can suit you well.
Are You Ready to Secure Your Funding?
Every year businesses fail, and part of the reason is due to a lack of adequate and timely funding. To avoid suffering a similar fate, you need to be aware of the financing options available that suit your firm. Term loans are a source of much-needed capital. To identify the right option for you, it’s important to understand the proper term loan definition and the strengths and weaknesses of each type of loan.
Your FundingTree is your quick and easy source to obtain business financing from banks and other industry-specific lenders. Apply today for the loan that’s best suited to help your business grow.