What Is a Business Term Loan and How Does It Work?

Business term loans are one of the most popular ways to secure funding for your business. Whether you’re looking to expand, purchase new equipment, or simply cover cash flow gaps, term loans can provide the financial flexibility you need.

But how do they work, and are they the right choice for your business?

Let us guide you through business term loans: benefits, drawbacks, alternatives and what’s required to qualify.

What is a business term loan?

A business term loan provides you with a lump sum of money that you repay over a fixed period of time, or “term.” Your scheduled payments are typically monthly or weekly and include a portion of the loan principal, interest and any fees the lender charges.

Term loans are often used for long-term investments, such as growing operations, acquiring equipment, or purchasing real estate.

Because this type of business financing usually comes with a fixed interest rate, term loans offer predictable repayment schedules, making financial planning easier for small business owners.

Lenders that offer term loans include traditional banks, credit unions, and online lenders.

How does a business term loan work?

Here’s how a business term loan typically works.

Applying for a business term loan.

The loan application process for a business term loan typically starts with a pre-qualification step to determine your eligibility. Lenders determine your eligibility based on factors like time in business, annual revenue and your personal or business credit score.

Next, you’ll need to provide key documents — such as financial statements, bank statements, tax returns and business plans — to support your application. Most loan applications also ask you to provide business checking account information.

Once all necessary information is submitted, the lender reviews your information and provides a decision. This process is called underwriting.

Borrowing and repayment terms.

If you’re approved for a business term loan, you’ll be presented with a contract, or loan agreement. You may be charged an origination fee, which is a fee to cover the loan processing costs.

By signing your contract, you agree to pay back the loan over a repayment period. After you sign, you’ll receive an upfront lump sum of money from your lender.

Making payments.

With a business term loan, you’ll make consistent monthly payments according to your agreed-upon repayment schedule. These fixed payments, typically referred to as installments, will apply toward the loan’s principal, interest and any fees.

The pros and cons of a business term loan.

Like any financing option, business term loans come with benefits and drawbacks. Understanding your loan options can help you decide if a term loan aligns with your business goals.

Pros

• Large loan amounts. The loan amounts associated with long-term loans may be suitable for growth-oriented projects or significant investments.
• Predictable payments. With fixed interest rates and amortized schedules, you’ll know exactly how much to budget each month.
• Business credit benefits. Consistently repaying your term loan helps build business credit history.

Cons

• Less flexible than other types of financing. Payments begin immediately, regardless of when you utilize the funds.
• Cash flow strain. High periodic payments could strain businesses with inconsistent revenue streams.
• Longer approval processes from traditional lenders. Traditional banks and credit unions can take a while to provide a decision. The process can stretch for weeks and require significant documentation.

When is it a good idea to take out a business term loan?

Term loans are suitable for larger, one-time expenses and are less ideal for ongoing financing needs. A business term loan may be worth considering when you’re seeking a reliable source of funding for a defined, long-term goal. Here are some situations when it may be a good fit:

• Buying expensive equipment or machinery
• Gaining working capital
• Investing in inventory ahead of a busy season
• Renovating or expanding commercial real estate
• Hiring new employees
• Consolidating existing debt

If your expenses are ongoing or unpredictable, consider exploring a business line of credit instead of a term loan.

What do I need to qualify for a business term loan?

Different lenders have different requirements, but make sure you meet typical eligibility requirements before applying for a term loan. These may include:

Time in business. Most lenders require at least 1-2 years of operational history. Some online lenders may accept companies with just 6 months of experience.

Credit score. You’ll need credit history to borrow a business loan. For traditional bank loans, a personal credit score of 680+ is typically required. Some online lenders accept scores as low as 550, although you may pay for it in the form of higher interest rates.

Annual revenue. Traditional lenders can require $100,000+ in revenue. Some online lenders accept businesses generating $50,000 annually.

You’ll also need to prepare documents, such as:

• Tax returns
• Business financial statements
• A business plan (for some lenders)

Keep financial records current, and consider consulting an accountant before applying for small business loans.

What are some alternatives to business term loans?

If a term loan doesn’t meet your small business needs, here are some alternatives:

Business line of credit

A business line of credit is a revolving credit line that allows you to draw funds as needed, up to a fixed limit. It functions similar to a credit card — you only pay interest on what you draw, and funds replenish as you pay back your balance.

A business line of credit is best for flexible spending and managing short-term cash flow gaps. It also provides quick access to capital for emergencies or scaling. However, interest rates may vary, and credit lines often come with annual fees.

Invoice factoring

Invoice factoring involves selling unpaid invoices to a factoring company at a discount to receive immediate cash. It tends to work best for businesses with outstanding invoices seeking short-term liquidity.

Although invoice factoring may work for businesses with less-than-perfect credit, high fees can add up over time, and the total payout from your invoices will be reduced.

Merchant cash advance (MCA)

A merchant cash advance is a lump sum advanced in exchange for a percentage of future credit card or debit sales. It can be a great fit for businesses with strong sales but limited access to traditional loans.

There are no fixed monthly payments, because you repay based on sales. However, MCAs come with extremely high fees, and it may cause cash flow issues if sales slow.

SBA loans

SBA loans are term loans backed by the Small Business Administration, offering low interest rates and long terms. However, the approval process is lengthy, and there are strict qualification requirements.

When considering term loan alternatives, weigh the costs and benefits of each option based on your business’s revenue, creditworthiness and immediate needs.

The Bottom Line

A business term loan can be a strategic tool for fueling growth, weathering financial hurdles or pursuing a major opportunity. However, it’s essential to assess your business needs, cash flow and repayment ability when deciding if it’s right for your small business.