Small Business Loan Terms: What You Need to Know

Most businesses think of a term loan when they think of small business financing.

If you’ve ever had a car loan or a home mortgage, you’ve had at least one type of term loan. The “term” in “term loan” refers to the period of time in which you make payments—typically expressed in either a number of months or a number of years. In other words, a term loan refers to a loan that has a specified repayment period and there are many types of small business term loans.

A small business term loan is used to meet a business’ capital needs—purchasing inventory, buying expensive equipment, building a new building, or any other business-related expense that requires more capital than is immediately available within the cash flow of the business. The exact repayment term is usually determined by the useful life of the underlying asset or business purpose for which the loan is used. For example, a term of three or six months might make sense for purchasing quick-turnaround inventory that will be sold over the next three months while an expensive piece of industrial equipment might be better suited to a term that allows the business to spread the payments over several years.

Term loans are sometimes secured by the assets the loan is used to purchase, though other conditions could apply.

How Term Loan Payments Work

Term loan payments commonly combine an amortization of the debt. This means that each loan payment you make covers a portion of interest on the loan along with a portion of the principal loan balance. Term loans may come with fees that are set when you first take out the loan. These fees may be paid up front, or added into the loan balance. Because there is no hard-and-fast rule for how a lender does this, make sure and ask your lender about this during the application process.

Many lenders will require that you take out insurance on the asset you’re purchasing throughout the term of the loan when the asset being purchased is also being used as collateral for the loan. Nevertheless, there are lenders, including online lenders, who may not require specific collateral to approve a loan and therefore do not have the insurance requirement. This is another question you need to ask your loan provider. If they do require insurance, your lender has the option to advance these payments to protect their collateral, and may add these costs onto your loan balance with interest.

Term loans usually have late payment penalties for any payments not made by a specified due date. Many lenders, including many online lenders, will auto-debit payments directly from your business bank account—which could, among other things, help you avoid any late or missed payments. Periodic payments vary by lender and could include daily, weekly, or monthly payments.

Term Loan Interest Rates and Fees

Interest rates and fees vary depending upon the lender and can be influenced by the nature of the loan, the loan term, and the creditworthiness of the business borrower. Because there are differences in the way many lenders express their rates and fees, it can sometimes be confusing when comparing loans of different terms from different lenders.

There are a lot of reasons why costs, rates, terms, and fees are expressed differently, but this broad variation sometimes makes it difficult for a small business borrower to make an apples-to-apples comparison. Additionally, there are a number of different ways to view and consider loan costs, so it is hard to rely on a single pricing metric.012

As a result, in May of 2016, OnDeck helped launch an initiative of the three largest online small business lenders, and a leading national non-profit microfinance trade association (the Association for Enterprise Opportunity (AEO)), to produce a disclosure solution that would help standardize a common set of pricing metrics and make it easier for small business borrowers to assess their options. The initiative—developed through the Innovative Lending Platform Association (ILPA) – resulted in the creation of the SMART Box™ (“Straightforward Metrics Around Rate and Total” cost), an easy-to-read standardized disclosure that uses common verbiage, explanations, and calculations around a comprehensive set of pricing metrics.

The SMART Box isn’t intended to replace a lender’s current loan disclosure information or documentation, but rather is intended as a supplemental disclosure that identifies key pricing information to make it possible for a small business to assess different loan products and determine the right fit for the business’ need or use case. Regardless of whether or not your chosen small business lender uses the SMART Box disclosure, in addition to some basic considerations like amount borrowed, payment frequency and amount, and the term of the loan, understanding the following will help you make a more informed loan decision:

1. Total Cost of Capital (TCC): This metric will include all interest and any other fees that are a condition of receiving capital. This metric discloses the total dollar cost of the finance option, a crucial source of information for a small business owner borrowing for a use case that includes a defined ROI.
2. Annualized Percentage Rate (APR): For term loans, this metric provides the cost of capital—including fees that are a condition of receiving the capital. APR can be a good comparison tool especially when comparing loans of similar term (think home mortgage or auto loan), nevertheless it is not the interest rate applied or used to calculate the total dollar cost of the financing option. Navigant Consulting will validate that lenders using the SMART Box are using APR calculation methodologies.
3. The Average Monthly Payment: This metric will reflect the average monthly cash flow impact of repaying the finance option being considered. Regardless of whether the periodic payment is daily, weekly, or monthly, the average monthly payment provides a common benchmark for evaluating monthly cost.
4. Cents on the Dollar: This metric identifies the amount of interest (or Loan Fees, as applicable) paid for every dollar borrowed. This metric is exclusive of all other fees to allow for comparison with other common pricing metrics in commercial finance, including the factor rate, simple interest, and total interest percentage.
5. Prepayment Conditions: The SMART Box identifies whether there will be additional fees or charges for prepayment and what they may be. It also identifies if prepayment will result in any reduction in interest or applicable loan fee. This is intended to make any applicable prepayment policy readily transparent to the borrower.

The SMART Box disclosure assumes that the financing option will be repaid in its entirety according to the terms of the applicable agreement and that no payments will be missed.

Why Should You Consider a Term Loan?

There are many financing options available to small businesses today. Nevertheless, there are some capital needs that may be well suited to a term loan:

• Financing the purchase of equipment, machinery, and other tools for manufacturing, service, and repair
• Purchasing technology and other office equipment, such as computer equipment, phone systems, copiers, furniture, and point-of-sale (POS) systems
• Buying real estate, office space build out, renovations, and new construction
• Depending upon the loan term, purchasing quick-turnaround inventory or any other short-term business need

Where Do You Apply for a Term Loan?

Term loans are available at traditional lenders like banks and credit unions, finance companies, as well as online small business lenders. Some equipment and business vehicle manufacturers also have divisions they call “captive finance” companies that offer term-loan financing for the sale of their products.

Some non-bank lenders that specialize in financing working capital also offer term loan products to their established clients.

How to Apply

Depending upon the lender, the requirements vary, so you’ll want to understand what you’ll need to make the application before you talk to a loan officer or apply online. As a starting guideline, traditional lenders are looking for information that may include:

• A well-formed and detailed business plan that explains why you need the financing, exactly what you will do with the loan proceeds, and how you expect your business to benefit from the purchase, etc. may be required for a loan at the bank
• Business financial statements for up to the last three years, including balance sheets and profit and loss statements (P&L)
• Tax returns for the business and its owners for the past three years
• A debt schedule
• Personal financial statements for all the business owners
• The lease for the business premises, if applicable
• Financial projections for three years showing what you expect revenue and expenses to be and demonstrating that operations will be able to repay the proposed loan
• Resumes for all the business owners and key employees
• Information about the assets to be purchased, including a copy of the sales contract or purchase agreement, if applicable

The information many online lenders require usually includes at least the following:

• Your Social Insurance Number
• Your Business Tax ID
• Connection to your business bank account, or paper bank statements (for certain lenders)
• Financial statements may be required (for larger loan sizes)

The lender will also likely obtain credit reports from the appropriate credit bureaus (including the owner’s personal credit as well as the business’ credit profile).

Decision time and capital distribution time vary depending upon the individual lender. Many online lenders are able to approve or decline a loan application within hours (sometimes as quickly as under an hour) and deposit funds into the business bank account within a day or two. The process can take much longer at a traditional lender like a bank or credit union—sometimes several weeks.

A term loan can be a good option for many small business financing needs. Like any loan, it’s important to make sure you understand your loan purpose, the amount of capital you really need to meet the loan purpose, and understand you credit profile before you start looking for a small business term loan.

Click HERE if you’d like to apply for a term loan with OnDeck.