Term loan
What it means
A term loan is a type of business loan. You borrow a set amount up front and pay it back in regular instalments, usually monthly, over a fixed period, with interest.
It's not the same thing as a loan term, which is simply how long any loan lasts.
See also: Loan term, Typical business loan terms
Why lenders ask
A term loan is a commitment the lender lives with for years, so they want to know the business can carry it the whole way. They look at cash flow first: can the business cover the new payment plus the debt it already has, with room to spare? Then security: most term loans are secured by the asset being bought, and often by a general security agreement over the business's other assets. For small businesses, owners are usually asked to personally guarantee the loan. And lenders rarely finance the full cost of a purchase, so expect to put in some of your own money.
How long is a term loan?
It depends mostly on what the money is for. A loan for equipment is usually amortized over the equipment's appraised useful life, while a loan for a building runs much longer. The lender wants the loan paid off before the thing it bought wears out or loses its value.
Equipment and vehicles are usually paid off over several years, leasehold improvements are often limited to what's left on your lease, and commercial real estate is often amortized over 15 to 25 years with a rate that renews every few years. Actual terms depend on the lender, the asset and your business.
Buying a business: share purchase vs. asset purchase
If the loan is to buy an existing business, how long you can take to repay depends on what you're actually buying. There are two ways to structure the deal.
In an asset purchase, you buy the business's assets, such as equipment, vehicles, inventory and sometimes real estate, rather than the company itself. Usually you set up a new company, sometimes under a new name, and the assets move into it. Because the lender is financing real assets, each one can be amortized over its useful life, which often allows a longer repayment period.
In a share purchase, you buy the shares of the existing company from the owner, and the company carries on as it was. From the lender's point of view, you're financing a piece of paper rather than a specific asset, so amortizations are generally shorter. If the company owns a major asset, such as a building, that part may support a longer amortization, but overall expect a shorter repayment period than an asset purchase.
The structure can change your monthly payment a lot. Talk to your lender and your accountant about it early, since it also affects taxes and which of the company's past liabilities you take on.
What would the payment be?
As an example, a $100,000 term loan repaid over 5 years at 7% works out to roughly $1,980 a month, or about $18,800 in total interest. Stretch the same loan to 7 years and the payment drops to about $1,510 a month, but the total interest rises to about $26,800.
This rate is for illustration only. The rate you're offered will depend on your lender and your application.
Term loan vs. line of credit
A term loan is borrowed once and paid down to zero. A line of credit works more like a credit card: you draw on it as you need to, pay it back, and draw again. Lines of credit are meant for short-term needs like covering the gap until customers pay you, while term loans are meant for things the business will use for years.
Using a line of credit to buy long-lasting assets is a common mistake, because it leaves no room on the line for the everyday swings it was meant for.
Lenders see this often: a healthy business pays for equipment out of its operating line or its cash, then comes in short on working capital. If you're buying something that will last for years, ask for a term loan for it up front.
Common questions
Can I pay off a term loan early? Often yes, but fixed-rate loans may charge a prepayment penalty. Ask before you sign.
Fixed or variable rate? A fixed rate gives you a predictable payment for the term. A variable rate moves with the lender's prime rate and is usually more flexible if you want to pay the loan down early.
Do I need collateral? Usually. The asset being financed is the main security, and the lender may ask for more, such as a general security agreement or a personal guarantee.
Good to know
If you're applying for a term loan, the Loan Ready calculator shows how its monthly payment fits with the rest of your cash flow.