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Why Term Loans Are a Favorite Among Small Businesses

Donna Fuscaldo
Donna Fuscaldo
Senior Finance Writer

Term loans are a popular funding tool thanks to their fixed payments and low interest rates.

Whether you're looking to finance costly equipment or to borrow money to fund your operations, a term loan may be a good option. These are business loans that you pay back over a set period, such as 18 months. Some business owners prefer them because the repayment amounts stay the same each month, and the interest often doesn't fluctuate.

"Term loans encompass a wide range of loans," Melissa Wylie, senior small business writer at LendingTree, told business.com. "There's working capital loans, inventory loans and more general finance for business owners. Term loans can be a great starting point."

[Check out our best picks and buying guide if you're looking for a small business loan.]

What is a term loan?

When you take out a term loan, you receive a lump sum of money that you must pay back over a fixed period. Payments are due weekly, biweekly, monthly or quarterly. The interest rate you pay on a term loan is either fixed or variable. If it's fixed, you'll pay the same interest over the life of the loan. If it's variable, interest may fluctuate. Mortgages, SBA loans and car loans are some common term loans.

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How does a term loan work?

Term loans work like any other borrowing product. You apply for term loans through a lender, who will either approve or reject your application. If you're approved, you'll receive a lump sum of money upfront and loan repayment terms, which include interest. It's up to you to meet the payment obligations.

Term loans can be either secured or unsecured. With a secured loan, you have to provide collateral. If you default on the loan, the lender can come after that asset. An unsecured loan doesn't require collateral. They tend to have higher interest rates and are more difficult to obtain.

TipTip: There are several types of term loans, with varying interest rates and payback requirements. You should research all your financing options before borrowing money.

When should you use a term loan?

Small businesses use term loans for many purposes, from bankrolling the purchase of pricey equipment to covering cash flow shortages. Here are some of the most common uses.

  • To purchase new equipment: With a term loan, you can purchase expensive machinery and equipment and pay it back in small installments, preserving more cash for your operations.
  • To support growth: Whether you want to bring on new employees or expand into new product categories, a term loan can help you grow.
  • To prevent cash flow shortages: Cash is king. If you face short-term cash flow issues, a term loan can help you bridge the gap.
  • To refinance debt: Debt can be a drag on profits. You can use a term loan with a lower interest rate to consolidate and refinance your unsecured debt.

There are several reasons to use a term loan, but there are also instances when it doesn't make sense. Borrowing money you can't afford to pay back is a big one. The same goes for making risky bets or using it for nonbusiness expenses.

"It happens all the time: Business owners borrow money for silly things like to have more cash flow personally or to go on a vacation," said Drew Giventer, CEO of Accountable Capital. "They lose sight of mixing their business and personal lives." 

What are the types of term loans?

Term loans can be equipment financing, working capital or installment loans. What differentiates them is the speed at which you pay them back. When choosing your terms, you have to weigh the cost of borrowing against the benefits. You don't want to be paying it back long after the asset or investment has value. A long-term loan makes sense if the equipment will depreciate over an extensive period, but a 60-month term loan isn't the best option to cover a short-term cash crunch.

"Longer terms mean small payments, but you could pay far longer than you want to," Wylie said. "A short-term loan is ideal if you need the loan right now to get through a slow season. It's really about balancing how much you can pay on a regular basis with how long you want to make loan payments."

FYIFYI: Small business lenders offer a lot of flexibility for paying back your loans. Many lenders will let you customize your repayment terms.

These are the main types of term loans:

  • Short-term loans: These are unsecured loans that you repay in 12 to 18 months. Payments are typically daily or weekly. Short-term loans tend to have higher interest rates than long-term loans. You can use them to cover expenses until your cash flow picks up again.
  • Intermediate-term loans: These loans have repayment terms of one to three years, typically with monthly payments.
  • Long-term loans: These loans' repayment terms can run anywhere from three to 25 years. Long-term loans are typically used for expensive equipment or property. Borrowers must make monthly or quarterly payments until they've repaid the loan.

What are the benefits of using a term loan to fund your business?

Small business owners might prefer term loans over other types of financing for several reasons. A big one is stability. You'll know exactly how much you owe and when it's due. That makes it easier to manage cash flow and to forecast. That can't be said of other loan products.

Term loans also tend to have lower interest rates and a simpler application process. You can write off the interest on your business term loan come tax time, and it can enhance your business and personal credit scores.

How do you apply for a term loan?

Before you apply for a term loan, comparison shop between lenders. The interest rate you'll pay can vary by lender, type of term loan and your credit score. Make sure to look at the APR, or annual percentage rate, rather than the interest rate when comparison shopping. The APR tells you the total cost of the loan.

FYIFYI: The interest rate lenders quote doesn't tell the whole story; the APR does. It shows you the total cost of the loan, including the lender's fees.

Your credit score will play a big role in the interest rate you pay and whether you'll get approved. That's why it's important to know your business and personal credit scores before you shop for a loan, to help you narrow down your options. Pore over your credit reports to ensure there are no errors hurting your status in lenders' eyes.

Lenders have different underwriting criteria, but most look at your business and personal credit score, cash flow, business and personal assets, time in business, annual sales, and business plan. It pays to gather all your documentation – including tax returns, income statements and bank statements – before filling out the application. That will speed up the underwriting process.  

When you're searching for a small business loan, you'll find that options abound, even if you have bad credit or a new business.

"Lending programs are everywhere," said Matt Vannini, president and CEO of Restaurant Accounting Services. "Don't make the assumption that you can't qualify."

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Donna Fuscaldo
Donna Fuscaldo
business.com Staff
Donna Fuscaldo is a senior finance writer at business.com and has more than two decades of experience writing about business borrowing, funding, and investing for publications including the Wall Street Journal, Dow Jones Newswires, Bankrate, Investopedia, Motley Fool, and Foxbusiness.com. Most recently she was a senior contributor at Forbes covering the intersection of money and technology before joining business.com. Donna has carved out a name for herself in the finance and small business markets, writing hundreds of business articles offering advice, insightful analysis, and groundbreaking coverage. Her areas of focus at business.com include business loans, accounting, and retirement benefits.