Term loan",

What Is a Term Loan?

A term loan is a sum of money borrowed by a business from a lender, such as a bank, that is repaid over a specified period with a predetermined interest rate and fixed payment schedule. This form of debt financing is a common way for companies to fund major expenditures, expand operations, or manage working capital needs. Unlike a revolving line of credit, a term loan provides a lump sum upfront, which the borrower repays in regular installments of both principal and interest.

History and Origin

Commercial lending has a long history, tracing its roots back to ancient Mesopotamia where early forms of loans involved agricultural commodities. In the United States, commercial banking began to formalize in the late 18th century, with institutions like the Bank of North America in 1781 playing a crucial role in providing funds to both public and private sectors. Early commercial banks pooled wealth from savers and channeled it to businesses, often through the discount of short-term commercial paper, which served as a precursor to modern business loans. As the economy evolved, so did the complexity and types of loans offered, moving from primarily short-term commercial paper to include longer-term arrangements needed for capital investment.⁴

Key Takeaways

A term loan provides a fixed amount of capital upfront, repaid over a set period.
Payments typically include both principal and interest, often on a monthly or quarterly basis.
These loans are commonly used for specific business investments like equipment purchases or expansion projects.
Lenders often require collateral and assess the borrower's credit risk.
They may come with specific covenants that the borrower must adhere to throughout the loan's life.

Formula and Calculation

The calculation for a term loan, particularly for regular payments, typically follows the standard formula for an amortizing loan. This formula determines the fixed periodic payment required to pay off the loan's principal and interest over its maturity date.

The payment (P) for an amortizing loan is calculated as:

P = \frac{L [i (1 + i)^n]}{[(1 + i)^n – 1]}

Where:

(P) = Payment amount per period
(L) = Loan amount (Principal)
(i) = Interest rate per period (annual rate / number of periods per year)
(n) = Total number of payments (loan term in years * number of periods per year)

This formula is fundamental to creating the amortization schedule for the term loan.

Interpreting the Term Loan

Understanding a term loan involves assessing its structure and implications for a business's balance sheet and cash flow. The fixed payment schedule provides predictability, allowing businesses to forecast expenses accurately. The duration of the loan, whether short-term, intermediate-term, or long-term, dictates the size of the periodic payments and the total interest paid over the life of the loan. Shorter terms typically mean higher individual payments but less overall interest, while longer terms result in smaller payments but more total interest. The interest rate, whether a fixed-rate loan or a variable-rate loan, also significantly impacts the cost of borrowing and must be considered in the context of prevailing market conditions.

Hypothetical Example

Consider a small manufacturing company, "Widgets Inc.," that needs to purchase new machinery costing $150,000 to increase production capacity. Widgets Inc. approaches its bank for a term loan.

The bank offers a 5-year term loan at an annual interest rate of 6%. The loan requires monthly payments.

Here's a step-by-step calculation:

Loan Amount ((L)): $150,000
Annual Interest Rate: 6%
Monthly Interest Rate ((i)): 6% / 12 months = 0.005
Loan Term: 5 years
Total Number of Payments ((n)): 5 years * 12 months/year = 60 payments

Using the loan payment formula:

P = \frac{150,000 [0.005 (1 + 0.005)^{60}]}{[(1 + 0.005)^{60} – 1]}

P \approx \frac{150,000 [0.005 (1.34885)]}{[1.34885 – 1]}

P \approx \frac{150,000 [0.00674425]}{[0.34885]}

P \approx \frac{1011.6375}{0.34885}

P \approx 2,899.98

Widgets Inc. would make approximately $2,899.98 in monthly payments for 60 months to fully repay the $150,000 term loan. This predictable payment allows Widgets Inc. to budget effectively for its new equipment.

Practical Applications

Term loans are versatile and feature prominently in corporate finance for various purposes. Businesses use them to finance capital expenditures such as acquiring property, plant, or equipment, which are long-term assets. They are also employed for business expansion, including opening new locations, entering new markets, or funding significant research and development projects. Furthermore, companies might use term loans for strategic initiatives like mergers and acquisitions, or for refinancing existing, higher-cost debt. The ability of banks to offer such credit facilities is influenced by broader economic conditions and their own lending standards. The l³andscape of business lending is dynamic, with shifts occurring in how companies access capital, including the rise of alternative lenders and financial technology (FinTech) firms, especially for small and medium-sized enterprises.

L²imitations and Criticisms

Despite their utility, term loans come with certain limitations and potential criticisms. The most significant is the repayment obligation, which can strain a business's cash flow if revenues decline or unexpected expenses arise. Failure to make payments can lead to default and the potential loss of collateral. Many term loans include restrictive covenants that dictate how a borrower must operate, such as maintaining specific financial ratios or restricting additional borrowing, which can limit a company's operational flexibility. Historically, banks have faced challenges in accurately assessing borrower creditworthiness, particularly for new or smaller businesses, leading to specialization in shorter-term lending. Furth¹ermore, while technology aims to streamline corporate lending, legacy systems within traditional banks can sometimes lead to inefficiencies and slower processing times compared to newer entrants in the lending market.

Term Loan vs. Revolving Credit

A term loan and revolving credit are both forms of debt financing, but they differ fundamentally in structure and purpose.

Feature	Term Loan	Revolving Credit
Amount	Fixed, lump-sum disbursement upfront.	Flexible, ongoing access up to a credit limit.
Repayment	Fixed, scheduled payments over a set term.	Payments based on outstanding balance; principal can be re-borrowed.
Purpose	Often for specific capital expenditures, long-term investments.	Typically for short-term operational needs, managing cash flow fluctuations.
Availability	Funds are disbursed once.	Funds become available again as debt is repaid.
Cost	Interest charged on the initial principal amount.	Interest charged only on the drawn amount.

The key distinction lies in the access to funds and the repayment structure. A term loan provides finite capital for a specific period, while revolving credit offers continuous access to funds that can be borrowed, repaid, and re-borrowed as needed, much like a credit card for businesses.

FAQs

What types of businesses typically get term loans?

Term loans are suitable for a wide range of businesses, from small and medium-sized enterprises (SMEs) to large corporations. They are particularly common for established businesses with a solid financial history and predictable cash flow that need funding for specific projects or assets.

Are term loans secured or unsecured?

Term loans can be either secured or unsecured. A secured term loan requires the borrower to pledge assets, such as real estate, equipment, or inventory, as collateral. An unsecured term loan does not require collateral but typically comes with higher interest rates and stricter qualification criteria due to the increased risk for the lender.

How long does it take to get a term loan approved?

The approval process for a term loan can vary significantly. It depends on the lender, the complexity of the borrower's financial situation, and the completeness of the application. The underwriting process involves detailed financial analysis, which can take anywhere from a few weeks to several months for larger or more complex loans.

Can a term loan be repaid early?

Many term loans allow for early repayment, but some may include prepayment penalties. These penalties compensate the lender for the interest income lost due to the early repayment. It is crucial for borrowers to review the loan agreement carefully to understand any terms related to early repayment.