Whether or not you realize it, there’s a high likelihood that you know what a term loan is. Or at least understand the concept. (We’ve talked about them before here at Smansha.) Term loans are the most traditional type of business financing available, where you work with a lump sum of capital and repay it in fixed installments along the way.
How term loans work
With a business term loan, you work with a lender to obtain a lump sum of capital that you borrow for a predetermined amount of time. You work out terms with your lender that are contingent on your creditworthiness, business history, and the amount of capital you ask for. And, once approved, you receive all of the cash at once.
Every lender will want to know what you’re doing with the money before you get the green light. But some term loans have restrictions on what you can and can’t do with the money, while others don’t.
But, essentially, term loans are business loans in the most traditional sense that most are used to when they think of financing. You borrow money, and you repay it through fixed payments, with interest, until your set term is up.
Short- and long-term business loans
Term loans come in a few flavors, so to speak. Short- and long-term business loans differ in — you guessed it — their term (how long you have) to pay back the money.
With short-term loans, you’ll generally have faster access to capital with shorter approval processes and less stringent requirements for qualification. The tradeoff is that the terms are less favorable. That means a higher interest rate and a shorter period by which you’ll need to pay back the cash. A short-term loan is generally a loan that lasts less than a year, though they can sometimes extend to around 18 months. Repayment on short-term loans is also usually daily or weekly.
With medium- or long-term loans, the process slows down. As you’d expect, these have longer repayment periods than those of their shorter counterparts, sometimes by several years. They often lower interest rates, too.
As a result, though, these loans only go out to more qualified borrowers, and the underwriting process takes longer. After all, a bank or alternative lender doesn’t want you to have their money for years if you’re not going to be responsible with it. On these term loans, you’ll generally have monthly repayments.
Term loans vs. other types of business loans
Although the most traditional type of business financing, term loans aren’t the only kind, of course. These are a few common alternatives and their most relevant uses:
- Business line of credit: Instead of a lump sum deposited into your bank account, a business line of credit works as a sort of hybrid between a credit card cash advance and a term loan. You’ll work with a lender to get approved for a sum, but you only use what you need — and only pay interest on what you draw. It’s a great solution for many business owners who want access to fast capital, but don’t necessarily want to have a large interest payment looming over their heads.
- Invoice factoring: An expensive short-term loan isn’t usually the best solution for an entrepreneur with liquidity issues. Invoice factoring lets you sell unpaid invoices to lenders (factors) who’ll pay you a percentage of the invoice, work with the vendor to collect the balance and return the rest to you, minus interest and fees, when the balance is paid. It’s an excellent alternative for capital tied up in trade credit, and generally more cost effective than other types of shorter-term financing.
- Equipment financing: If you don’t need working capital, and are rather looking to finance a specific purchase of gear for your business, you should consider equipment financing. As what’s called a “self-collateralizing” loan, equipment financing uses the equipment funded with the money you borrow to secure the loan. For that reason, some borrowers with less-than-perfect credit can obtain this type of business financing.
The best uses for a term loan
You can seek a term loan to finance a lot of different scenarios over the life of your business.
For one, a term loan is a good source of working capital. In other words, you’d borrow from a lender in order to have a source of money to spend freely on general day-to-day operating costs (as opposed to directly investing into an asset). If business owners are in a cash pinch, it’s fairly common to seek out short-term financing in order to supplement their cash flow.
Times when short-term loans make sense include:
- Making payroll or paying taxes.
- Funding a marketing campaign.
- Opening up a new location or expanding into a new market.
- Financing the creation of a new product or service.
- Covering a one-time expense, like an emergency repair.
Longer-term loans are also good for specific investments or asset purchases. You can also use a term loan to refinance existing debt — meaning if you have an existing loan and you’re in a better financial position with better credit history, you can work with a lender to refinance into a less expensive product with more favorable terms.
And when you wouldn’t want to apply for a term loan
Taking on debt is never preferable, of course. But if you’re going to apply for business financing, the benefit of a term loan is its predictability. You apply for a fixed amount of money. And, when you work with a lender, you’ll know up front how much you’ll owe each month, plus how much the loan will cost you by the end in terms of its interest plus principal.
If you’re not entirely certain that your investment will yield results, or you’re in a somewhat precarious financial position, taking on a term loan might not be advantageous. There are other financing instruments, like those we mentioned above, that could be a better fit for you.
Additionally, term loans almost always require collateral. You want to make certain that you don’t put your business in a situation in which you’re taking on debt that you aren’t sure you can afford. That puts your collateralized assets at high risk — and could ultimately jeopardize your entire company, especially if your lender requires a blanket lien on your tangible assets.
How to apply for a business term loan
If a term loan is a fit for your business’s needs, you’ll need to work with a business lender to obtain financing. You have a few options: You can go directly to a bank or credit union, or work with an online lender (alternative lender).
A bit of context is helpful before we go further, though. Small business lending took a big hit during the 2008 financial crisis. And although Main Street lending rehabilitation was meant to be a mandatory provision within the government’s Troubled Asset Relief Program (TARP) bailout, rehab help never quite made it into practice. Ten years later, the vast majority of American small business owners still find it very difficult to get loans from institutional lenders like banks. They can be picky with their candidates — and they are.
While that little recap covered the United States, SMEs around the world face similar challenges accessing funds through institutional lenders. Worldwide, there’s an unmet funding need of $2.1 – 2.5 trillion.
Where to look for a term loan
Let’s start with those bank loans. If you have several years in business, strong and consistent revenues with a consistent track record, and excellent credit, you could be a good candidate for a bank loan. As a new business, you’ll definitely need to look elsewhere. Because banks don’t lend out much money to small business owners, they can be choosy — and they’ll choose the least risky candidates. To them, that means ones with proven dependability with debt. An existing relationship with a bank is often helpful, too.
Alternatively, online lending has emerged in recent years as a response to the lack of available capital for small business owners. Qualifications won’t be as stringent with most online lenders, but their terms will be slightly less favorable as a result. You can apply for term loans directly at lenders’ websites, or through online loan marketplaces, who can submit your information to multiple lenders at once.
What lenders look for in a qualified term loan applicant
The most important thing to remember when trying to understand business loan application requirements is the lender’s job. It’s all about mitigating their risk.
There’s no way to conjure the future in a crystal ball to know whether or not they’re going to get back their money — that’s impossible. So, when evaluating your application, they have to make the decision based on your odds of paying them back. That’s all derived from your track record. And, since they haven’t known you for years and can’t sample just how good your product is or meet you to understand just how trustworthy you are, all they can judge are things including:
- Financial statements, including your cash flow statement, balance sheet, and income statement.
- Recent business bank account statements.
- Credit rating — both personal and business.
- Tax returns — both personal and business.
As with all business loans, requirements for term loans will vary from lender to lender.
As we mentioned before, banks and credit unions will require very strong financials. You’ll nee high credit scores (generally very good to excellent) as well as more than a couple of years in business under your belt with good earnings so they’ll have financials to analyze. Online lenders might require slightly less solid credit or revenue numbers and a little less time in business.
That said, term loans aren’t the best options around for new businesses. Most lenders require some established financial track record for your business to qualify. Startups simply don’t have that.
The relationship between term loans and cash flow
There’s a deep connection between term loans and your cash flow. It starts before you even apply for one of these financing instruments, and continues after you’re approved.
Why lenders care about cash flow
Cash flow is an extremely important metric for small business lenders and loan underwriters. It’s a make-or-break factor that’ll determine whether or not you get approved for your loan.
And if you think about it, that makes sense — your cash flow reflects the money you have available to cover your loan payments. Lenders will evaluate your cash flow statement to make sure you consistently have enough cash on hand to cover both your operating expenses and your debt.
Before you apply for a small business loan, you’ll want to have been keeping a detailed cash flow forecast. It’s one of the only dependable ways to know if you’re in a position to take on the financing you think you are. In other words, see what lenders see — don’t be surprised!
Where you’ll see your loan payments reflected
Got approved for a term loan? Great! Make sure you know where it’s showing up so you make sure you do make those loan payments and don’t fall behind. And, as we’re sure you’re unsurprised, your financing will appear on your cash flow statement, too.
What’s called your cash flow from financing activities (CFF) encompasses these outflows. At Smansha, we recommend running a cash flow forecast (like the one below) every month so you can see how your business’s CFF is affecting you.
How to improve your cash flow position
No matter where you are in the term loan process, make sure you have your cash flow processes zipped up tight. An in-depth cash flow forecasting tool will help you on either end.
- If you haven’t yet applied for a term loan — understanding the trends in your business and creating a forecast will allow you to get your finances in the best possible position for approval. And to get better terms for a less expensive loan.
- If you’re ready to apply — have as many insights into your cash flow as possible so you never miss a payment — and you know as fast as possible if you’re going to come upon a cash flow gap.
Spot risk now, thank yourself later. Smansha’s insights and analysis also provide you with a risk score, based on numerous data points, that shows you how creditworthy potential lenders and business partners see you.
Signing up for Smansha is easy. Just create your free account, connect your business and run your forecast.
The information in this article is not financial advice and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
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