Business Loan Terms: How to Pick the Right Financing Term
When you pursue a term loan, you’ll be provided with a set loan amount that you’ll need to pay off in a specific length of time. Typical business loan terms range from one to five years, but long-term business loans can last up to 10 years.
Naturally, the wide range of term lengths can be very intimidating to small business owners, especially if they’re first-time business loan applicants. Because of this, you should take the time to research different business lenders and their term options.
Before you select your ideal business loan term, you should be able to answer two essential questions:
How much additional working capital does your business require?
What do you need the money for (equipment, real estate, inventory, etc.)?
Although loan terms are very important, you can’t decide on the best business loan term until you’ve first answered these questions.
For example, let’s say you need $1,000,000 to finance the construction of a small apartment complex that you plan to sell. Ideally, the life of the loan should end around the time you realize revenue from the sale of the building. You can repay your business loan with sales proceeds and stop paying interest.
Of course, construction loans are designed for a specific purpose. On the other hand, business loans can fund anything from inventory and marketing to mergers and acquisitions. Therefore, for traditional business loans, the ideal term varies considerably.
It’s essential to consider your preferred loan term before starting the loan application process. This blog post will explain how business loan terms work so you can pick the right loan term.
Then, we’ll summarize the situations in which specific rates and terms work best. By the end of this post, you should be able to select a loan term that you can manage confidently.
How Do Business Loan Terms Work?
A small business loan’s term is the period from the date the loan closes (the Closing Date) and the date that the loan is terminated or repaid.
For example, when you get a mortgage on your home, your loan traditionally has a 30-year term. This means your loan payments are spread over 30 years, making it a long-term personal loan. Business loan terms usually don’t last 30 years, but the concept is the same.
Remember that you may also hear a business loan’s term called the “loan repayment period” or the “borrowing period.” Whenever you’re speaking about loan terms, you’re referring to the length of the repayment period.
What Is The Difference Between Short, Medium, and Long-Term Business Loans?
If you’re a small business owner researching additional financing, you’ve probably seen them referred to as short-term, medium-term, or long-term. What’s less clear is exactly what that means and how to select a term that fits your business’s financial needs. If you don’t select the right term length, you could risk hurting your business’s financial future.
Below, you’ll find an easy reference chart for the typical lengths of business loan terms.
| Loan Term | Length | Examples |
|---|---|---|
| Short | One year or less | Line of credit, bridge loans, microloans |
| Medium | One to five years | Student loans, equipment financing |
| Long | More than five years | Traditional business loan, mortgages, SBA 7(a) loan |
What to Consider When Weighing Your Business Loan Term Options:
As mentioned earlier, choosing a small business loan starts with determining how you’ll utilize the funds. Beyond that, though, you’ll want to consider two other important factors:
Potential interest costs
Cash flow
To consider interest costs, you’ll need to understand how different business loan terms affect interest expenses. Once we thoroughly explain this, we’ll detail how cash flow plays a part in this.
1. Interest Costs and Your Loan Term
Interest payments make up most of the cost you pay for a business loan. Since you pay interest over time, though, the term of your loan affects how much interest you pay. Understandably, you want to avoid paying high-interest rates.
For example, compare a $100,000 loan with a borrowing period of one year versus the same loan with a borrowing period of ten years.
Assuming these loans both have an interest rate of 10 percent, your interest expense for the 10-year loan would be $58,580.88. For the 1-year loan, your interest expense would be $5,499.06.
While this is an oversimplified example, it illustrates how interest costs vary based on your loan term. Assuming all else is equal, you’ll pay more interest expense on a loan with a longer-term versus a shorter term.
Keep this component in mind when you’re evaluating potential loan terms. While you should consider the cost of interest rates and other fees when researching your loan options, a long-term loan could still be in your business’s best interest.
If you take out a short-term loan, you’ll be expected to pay it off sooner, which in some cases may not be feasible. Just as your business should avoid taking out too long of a loan term, a short-term loan could lead to missed payments or other financial stresses.
2. Matching Cash Flow to Your Business Loan Term
Maintaining healthy cash flow is a crucial challenge for any small business owner, regardless of your business’s industry. To that end, you must choose a business financing term that aligns with your current and future cash flow needs.
As previously mentioned, with shorter loan terms, you’ll need to pay back your loan faster, so your payments will be relatively large. You may have smaller amounts with a longer-term loan, but they’ll extend over longer durations.
In either case, you need to ensure your payment dates and amounts align with other cash inflows and outflows. Otherwise, you can easily end up with no cash on hand to make your payments. If this occurs, you’ll be stuck with significant debt, which could hurt your business’s financial future.
In some cases, your lender may be flexible on your payment due dates so that they aren’t on top of other bill due dates. However, it’s up to you as the business owner to be aware of all of your financial obligations and ensure that you can responsibly afford all of them.
3. Consider Your Credit Score
Anytime you borrow money, your business loan or business line of credit offer will likely be contingent on your credit score.
Typically, business lenders prefer working with business owners with a strong credit history. This is because they have a good track record of paying off their balances. Although it is possible to get approved for a bad credit business loan, you may not be given an ideal loan term.
If this occurs, it might be best to work on improving your credit score before applying for a small business loan. To improve your credit score, we suggest taking measures such as:
Consolidate debt
Pay bills in full and on-time
Check your credit report to ensure that there are no mistakes. If there are any errors, contact the credit bureaus to fix them as soon as possible.
Improve other aspects of your business’s finances
Conclusion: A Final Note on Picking the Right Business Loan Term
Finding the right small business loan term is a balancing act. If you choose a term that is too long, you’ll pay more than you need in interest payments. However, if you select a loan term that’s too short, your payments could be unmanageable.
If you have trouble repaying your loan, you’ll risk your business’s credit score, in addition to your ability to qualify for future funding options.
On top of all that, long-term loan options typically allow for larger loan amounts. Due to this, if you need a large influx of cash, your decision may already be made for you. A long-term loan is usually advised for small business owners that need large loan amounts for expansion projects, expensive equipment, or other significant costs.
To simplify the application and find your ideal loan term, we’d recommend going back to the two questions we started this post with:
How much additional working capital does your business require?
What do you need the money for (equipment, real estate, inventory, etc.)?
Answer these questions, narrow down your list of business financing options, then compare the terms offered by those options. After that, it’ll be much easier to determine your ideal loan term.
Editor’s Note: This post was updated for accuracy and comprehensiveness in July 2022.