A term loan at the bank is what most people think of when they think of a small business loan—which is why it makes sense for this to be at the top of the list. What’s more, many of the other loan types share similar characteristics with a traditional term loan, so it makes sense to understand how a traditional term loan works.
Although it might not always be the best place for every small business to look first, it makes sense that many businesses start at the bank when they’re looking for a small business loan. They likely have other business banking accounts there, they have a relationship with the bank, and they may even have a personal relationship with the banker.
If you’ve ever had a car loan or a home mortgage, you’re likely familiar with the basics of how a term loan works—a small business loan may share many of the same characteristics. The word “term” refers to the period of time during which you make the periodic payments (30 years is a common term for a home mortgage, for example). Like a home mortgage, every term loan has a specified repayment period. A typical term loan at the bank for a business loan could be four, five, 10 years, or longer. The term is usually dictated by the loan purpose.
A traditional term loan is often used to purchase assets like real estate and equipment, but may also be used to expand a restaurant, build a commercial building, or to fill other business needs. There are many business capital needs that could be a good fit for a term loan.
The exact repayment term may be matched to the useful life of the asset being purchased. For example, the term for purchasing computer equipment or a copy machine will likely be very different from the term frequently associated with purchasing a commercial building, real estate, or heavy equipment.
How Term Loan Payments Work
Small business loan payments typically include a combination of interest and a portion of the principle balance in every periodic payment. The amount of interest and principle in the loan payment will vary, and is identified in an amortization schedule determined by the bank. Typically more interest is paid in the beginning of the loan term, and more principle is paid as the loan approaches the end of its term.
The fees associated with term loans can either be paid up front or added into the loan balance (depending upon your lender). Annual Percentage Rate (APR) is a reflection of the interest cost and fees charged expressed in an annual percentage rate. Auto loans, mortgages, credit cards, and other consumer debt is expressed in APR to make comparison shopping for consumers easier. Small business term loans from the bank may also be expressed in APR—making it one of several ways to compare small business loans. When comparing business loans with vastly different terms, however, using APR alone may not tell the full story. Instead, it should be considered along with the total loan cost, which will typically be lower on a shorter-term loan and help determine whether a loan is the right fit for a given business need.
Collateral for Loans
When applying for a small business loan, many banks will require some form of specific collateral to secure a loan. Collateral is an asset of value the lender will take ownership of should a borrower default on a debt. If the small business loan is intended to purchase some kind of asset, like a piece of equipment or real estate, the lender might use the asset being purchased as collateral. An easy-to-understand example from the consumer lending world is an auto loan. The car being purchased serves as collateral to the lender until the balance is paid in full, which is why the auto lender holds the title to the vehicle until the entire balance is paid—giving them the option of repossession should the borrower fail to make his or her auto payments.
Many banks will also require a borrower to insure an asset being purchased over the course of a small business loan (with an insurance policy acquired for that purpose), to protect the value of the asset being purchased with the loan proceeds. This may apply to a business loan for purchasing equipment or other similar asset. If the borrower fails to purchase adequate insurance, the bank may add those costs to the balance of the loan.
Bank Term Loan Rates and Fees
At the bank, the interest rate you’ll be charged will depend upon a variety of factors, including:
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The current index rate (usually the Prime Rate, LIBOR, or the Treasury Rate—based upon the type of loan)
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The perceived credit risk represented by your loan (your personal and business creditworthiness)
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The length of the loan term
Interest rates on a term loan can be either fixed or variable. A fixed rate will not change throughout the term of the small business loan, regardless of what happens within the capital markets. With that in mind, a good time to get a fixed-rate loan would be when interest rates are low.
A variable interest rate will be based upon an interest rate index (see above), which will be associated with the bank’s cost of capital. When you agree to a variable interest rate, you are agreeing to a rate based upon the index, plus a defined interest margin. In other words, as the lender’s cost of capital fluctuates, you interest rate can also go up or down within the term of the loan.
Why Would a Term Loan Make Sense for a Small Business?
With all the small business loan options available to a business owner today, a term loan could be a good fit for borrowers who meet the banks’ criteria because a term loan at the bank will often include the lowest interest rates. A traditional term loan could be a good fit for specific, high-cost purchases that will provide value to your business over a long period of time:
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Equipment, machinery, and other tools for manufacturing, service, and repair businesses
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Technology and other office equipment, such as computer equipment, phone systems, copiers, furniture, and other similar technology
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Real estate, office space expansion, renovations, and new construction
