Term Loans

Term loans are loans where a business borrows a lump sum generally from a bank for a fixed number of years. The amount of loan granted is the principal and the cost to the business from borrowing the money is the interest charged by the bank. Term loans are traditional instruments of debt used by businesses. They can be defined as amortized, intermediate term financing covering a period from 1 to 10 years.

Term loans are secured loans where a lien is created on the assets purchased with the loan proceeds or with other fixed assets of the firm or the personal assets of the borrower. The loan period generally depends on the expected working life of the asset purchased with the loan.

The interest rate charged will depend on the credit standing of the borrower and the assets pledged. Since these loans are for long periods, the interest rate is generally high. The borrower will also have to pay for other service charges like loan origination fees, legal fees and the cost of credit analysis as part of the installments. 

Typically, term loans are repayable in equal installments over the life of the contract. There are occasions however, when other alternative repayment options are available as decided in the term loan agreement:

  • Balloon Payment: Under this method, a large lump sum is paid at the end of the loan period.  During the loan period, the borrower may make some small payments which may not be regular.
  • Recapture Clause: If the term loan agreement includes the recapture clause, the borrower will have to repay the money before the prescribed loan period if the firm’s sales, cash flows or profits exceed projections.
  • Equity Sweetener: This gives the lender a stock option,  that is the right to purchase a specified number of equity shares in the borrower’s business at a low price.  This method is not used by commercial banks.  An equity sweetener compensates the lender for the risk he is taking by lending to the business.

When a Business Applies for a Term Loan, a Bank will Consider the Following Factors Before Granting the Request:

  • Credit Worthiness: The bank will consider the creditworthiness of the borrower-his personality, his sincerity and his management skills.  They will consider whether the business is likely to do well and be able to repay the term loan taken.
  • Cash Flows: The installment payment for term loans will start only when the business starts generating cash flows.  The bank therefore, will study the business plan and satisfy itself regarding the projected cash flows.
  • Risk: Before granting term loans, the bank will assist the risks involved in the business.  The loan requested may be rejected if the bank feels that the risks are too high.

Once Banks Grant Requests for Term Loans, the Business of the Borrower will go Through the Following Three Stages:

Project Implementation: In this stage, money moves from the bank to the borrower and the business utilizes it for the purpose for which the loan was applied.

Gestation: In this stage, the businesses start generating cash but would not have broken even.  There are no installment payments made to the bank at this stage.

Profit Earning: Once the business starts earning profit, the installment payments for the term loan begin.  Cash now starts moving from the borrower to the bank.  Ideally, the incoming cash flow should be at least 1.5 times the installment amount.

Term loans are suitable for businesses requiring a large amount of funds which they would like to slowly repay in installments over a long period of time.