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:
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.