Term loan

Definition

A term loan is a type of loan that provides a specific amount of capital to a business for a predetermined period, or term, with a fixed or variable interest rate.

What is a term loan?

This form of financing is widely used by businesses for various purposes, including expansion, equipment purchase, working capital, or other long-term investments. Term loans provide businesses with a lump sum amount, and the borrower is required to repay the loan over a set period through regular instalments.

Term loans can have fixed or variable interest rates. A fixed interest rate remains constant throughout the term of the loan, providing predictability for the borrower’s monthly payments. On the other hand, a variable interest rate may change over time based on fluctuations in a reference interest rate, such as the prime rate.

Term lengths can vary widely, ranging from a few years to several decades, depending on the purpose of the loan and the agreement between the borrower and the lender.

Term loans can be secured or unsecured. Secured loans require collateral, such as business assets, to secure the loan, providing the lender with a source of repayment in case of default. Unsecured loans do not require collateral but may have higher interest rates to compensate for the increased risk for the lender.

Lenders typically assess the creditworthiness of the business before approving a term loan. This evaluation considers factors such as the business’s financial health, credit history, cash flow, and the purpose of the loan.

Lenders may charge origination fees or other costs associated with processing and disbursing the loan. These fees contribute to the overall cost of borrowing.

Businesses may have the option to renew or refinance term loans at the end of their term, allowing for continued access to capital or adjustments to the terms based on the business’s financial circumstances.

Example of a term loan

Let’s say Company ABC, a small manufacturing firm, needs to purchase new machinery to expand its production capacity. However, they don’t have enough cash on hand to make the purchase outright.

Company ABC applies for a term loan of $100,000 from the bank to finance the purchase of the new machinery. After reviewing Company ABC’s application and financials, the bank approves the term loan. The terms of the loan include a principal amount of $100,000, an interest rate of 6% per annum, and a repayment period of 5 years.

Company ABC is required to repay the term loan in monthly instalments over the next 5 years. Each instalment consists of both principal and interest payments.

After 5 years of making regular monthly payments, Company ABC successfully repays the entire $100,000 principal amount of the term loan, along with the accrued interest. The loan is considered fully paid off, and Company ABC no longer owes any money to the bank.