Term loans are the most common types of loans for small businesses. They are very simple in that the lender provides a specific amount of money, usually at a fixed rate of interest, and there is a schedule for repaying the loan (usually in monthly or quarterly payments) over a certain amount of time.
Short-term loans may be for only a few months to provide working capital during a particularly busy season or for the purchase of new equipment. For the purchase of more expensive equipment, or for an expansion or remodel, an intermediate-term loan may be beneficial, with maturity in one, two, or three years. Long-term loans can be used to start up a business, open a second location, or make significant capital improvements. Short- and intermediate-term loans are the most common loans for small businesses.
Knowing the various types of loans and determining which one will best suit your needs is the easy part. However, obtaining the loan is a bit more challenging. Typically, banks lend money to businesses that already have money, which makes it very difficult for a new business to secure a term loan.
The big question that a lender wants answered is, “What can you offer in collateral for the loan?” An established business can put up accounts receivable, property, or equipment as collateral for a secured loan. For an unsecured loan, lenders will look at the credit history of the borrower and/or the business. For the small business that is a sole proprietorship or partnership and is not yet “established” (and unable to put up collateral), the responsibility to repay the loan will fall on the owners, who will likely be asked to provide a personal guarantee. It is therefore very important that before signing such a guarantee, you carefully determine what the loan is for, how it will benefit the business (from the perspective of increased profits), and how you could repay the principal if you had to.
Applying for a term loan can be a time-consuming process. Typically you are asked for:
- Financial statements for at least three years;
- Tax returns for the past three years;
- The type of collateral you can provide;
- Incorporation papers (if your business is a corporation);
- A personal guarantee for short-term loans, a new business, or if the collateral is insufficient;
- Your credit report;
- Your business plan.
You should also show that you have personally invested in the business. Lenders are more apt to give loans to business owners who have invested their own money in their business (and are therefore less likely to default on the loan).
For the commonly used short-term unsecured loans, lenders will look very closely at the borrower’s credit history, much in the same manner that they evaluate a potential borrower for a home mortgage. If you’re able to obtain a short-term loan and repay it quickly, it opens the door to obtaining other such loans much more easily, as you build up your credit rating and establish a relationship with the lender. In fact, even if you don’t need a loan, you should nonetheless try to obtain one for your business (provided you’re certain that you can pay it back on time), to enhance your credit rating, thus making it much easier to obtain a loan when you do need one in the future.
Term loans can be advantageous because you will have liquidity and greater financial flexibility while preserving your working capital. However, you must stay on top of the payment schedule. You’ll also want to be aware of all fees involved, which should be about 1 percent of the overall loan. Review in advance all the loan terms, including what fees will be charged. This will help you when shopping around for a loan and comparing not only interest rates, but overall term loan packages as well.