What is a term loan and how does it work?

A term loan is a type of business loan in which a lender provides a borrower with a lump sum of cash up front that is repaid with interest over a fixed period of time. This funding option can be well suited for major projects, expansions and other long-term business investments.

Business owners seeking capital for their business may want to consider applying for a term loan. Read on to learn more about this type of business financing.

What you’ll learn:

• Term loans provide borrowers with an up-front lump sum of cash that they repay with interest through regular installments over a set repayment term.

• They can be good financing options for major expenditures like purchasing commercial real estate or equipment.

• Terms may range from one year for smaller, short-term financing needs to 25 years for larger loan amounts.

• They can have stricter eligibility requirements and may not be the best option for newer businesses.

• To qualify for a term loan, businesses generally need to demonstrate strong financial health and provide business and personal financial documents.

A term loan is a lump sum of money that a borrower receives from a lender and repays, plus interest, at regular intervals over a specified period of time. Interest rates may be variable or fixed, meaning they can either remain the same throughout repayment or change based on the index rate.

Term borrowing is a common funding option for small businesses looking to expand, such as by purchasing equipment or real estate. 

A term loan is a type of business loan characterized by a consistent repayment schedule. A business line of credit works differently, allowing business owners to borrow from an available credit limit and repay only what they use, plus interest.

With a term loan, a lender disburses funds to a borrower in a lump sum of money. The borrower must then repay the principal amount of the loan, plus interest on the outstanding balance, in regular, usually monthly, installments. Oftentimes, each payment on a term loan goes toward both the principal and interest, with a larger portion initially applied to interest until both are paid off by the end of the term.

Because the conditions are specified up front, term loans are a popular choice for business owners looking to take on major projects with predictable costs and timelines. Depending on factors like the term length, the loan amount and the borrower’s business credit score, lenders may require the borrower to provide collateral to qualify for the loan.

There are three major types of term loans, defined by their respective term length: short, intermediate and long. 

Here’s more information about each type.

Short-term loans are generally meant to cover more immediate needs, like cash flow interruptions or emergency repairs. Repayment is usually due within a year, but could be as long as 18 months. They can be easier to qualify for, but may come with higher fees compared with longer-term loans.

Intermediate-term loans, or medium-term loans, are often used for moderate purchases like equipment, technology or marketing. Borrowers usually have one to five years to repay intermediate-term loans, which may offer a balance between repayment timelines and borrowing costs.

Long-term loans are intended to finance significant investments like commercial real estate purchases or business acquisitions. Because of their scale, borrowers may have five to 25 years to repay long-term loans, and the qualification requirements are often higher. Borrowers are more likely to need to put up collateral to qualify for a long-term loan.

Term borrowing may offer advantages like a consistent repayment schedule, lower interest rates compared with other lending options and retention of business ownership. But it may also feature disadvantages like inflexible repayment terms, strict qualification requirements and prepayment penalties.

Term loans can help businesses access structured financing with predictable repayment terms.

• Lower interest rates: Compared with other types of business financing, like merchant cash advances, term loans may come with lower interest rates.

• Consistent payment schedule: Especially for loans with a fixed interest rate, borrowers can expect consistent monthly payments, which can help with budgeting and cash flow.

• Ownership retention: As opposed to equity financing, taking out a term loan allows SBOs to retain full ownership of their businesses.

• The ability to build business credit: Since lenders often report to credit bureaus, making responsible payments on your loan can help you build a good business credit score.

• Potential tax benefits: Paying interest on a business loan may be tax deductible, depending on certain IRS criteria.

Term loans can provide predictable financing, but they may also come with limited flexibility.

• Strict qualification requirements: Generally, businesses need to demonstrate strong credit and a proven track record to qualify for term loans. This can make term loans less accessible for new businesses seeking funding.

• Inflexible repayment terms: Consistent repayment schedules can be challenging for businesses experiencing a dip in cash flow.

• Prepayment penalties: Some lenders may charge penalties for borrowers who repay their loans early.

To determine if a term loan is right for you, it may help to consider the following:

• Do you need a one-time lump sum of funding or access to ongoing funds? A term loan can be a good fit for meeting a specific need, like a significant purchase, while a business credit card may be better suited for increasing your everyday spending capacity.

• Do you have a strong business track record? If so, you may be more likely to qualify for a term loan. If not, you may want to familiarize yourself with other types of business loans to make sure you’re seeking the best kind of funding for your business needs.

• Can you afford to make fixed monthly repayments? Term loans often require regular payments over a set repayment period, so it’s important to determine whether your business can comfortably manage the repayment schedule.

To qualify for a term loan, lenders generally evaluate a business’s financial health and ability to repay the loan. Factors like business and personal credit scores, annual revenue, cash flow, time in business and existing debt obligations can all affect eligibility. Depending on the lender and loan amount, borrowers may also need to provide collateral.

To verify this information during the application process, lenders may request documents like your:

• Business plan

• Business tax ID number and personal IDs

• Bank statements

• Business and personal tax returns

• Accounts receivable (AR) and accounts payable (AP) statements

• Financial statements

• Relevant licenses, registrations and leases

• Collateral information

Term loans can be a great option for established businesses looking to expand with a predictable repayment process. But they’re far from the only funding options available to SBOs.

Another option is a Capital One Business credit card tailored to support your business needs. You can see if you’re pre-approved for a card today with no impact on your personal credit score.