Assuming you can get approved, term loans are a versatile tool for financing large, one-time investments and working capital. However, obtaining approval for this type of business loan is far from a foregone conclusion.
Certain term loans are only accessible to established businesses with years of profitability behind them.
With so many variables at play, there’s no simple way to determine if a term loan is right for your business. You have to carefully weigh the pros and cons of a term loan and evaluate them in the context of your business goals. To help you do that, this blog post will review the benefits and drawbacks of term loans.
The Pros and Cons of Term Loans
Before pursuing a small business loan, you should review the most notable pros and cons. That way, you can determine what most lenders that offer term loans expect, and determine if this is the right funding option for you.
The Pros of Term Loans
1. Predictable payment schedule
By definition, a
term loan has a specific loan amount that must be paid back on a specific schedule. Therefore, unless you have a floating interest rate, you know exactly what and when your payments will be. With a floating interest rate, your business loan rate may change (either up or down) and with it, your payment.
Certain financing types, such as merchant cash advances, don’t have this type of repayment predictability. Instead, with a cash advance, you'll receive lump sum financing that you'll remit based on your business's current credit card sales. As your credit card sales fluctuate, so will your remittance amount.
For some entrepreneurs, predictability is an advantage because it helps them make more accurate cash flow projections. By having a fixed interest rate and repayment amounts, you'll know how to monitor your business's budget.
2. Potential for early loan repayment
You’ll have to read your loan agreement to ensure you can repay your loan early without penalty, but in many cases, it is possible. Repaying your loan early can reduce your interest expense and makes it easier to take on new debt. Often, business owners take out short term loans so that they can use the financing and pay off their balance quickly.
This kind of flexibility allows you to adjust your plan if circumstances change. For example, if your interest rates decrease, you can
refinance your term loan and lower your monthly payment.
3. Lower interest rates
While their rates aren’t always the lowest, long-term loans tend to have lower interest rates relative to other financing options. This is because,
the longer your term, the more time your business loan has to accumulate interest.
However, while you’ll be paying more in total interest, your regular payments will be lower and their impact on cash flow will be less severe.
Of course, you want to strike the right balance by keeping your total interest paid and monthly payments both as low as possible.
The Cons of Term Loans
1. Inflexible repayment schedules
While a term loan’s repayment schedule is predictable, it’s also inflexible. Especially if the loan carries a
strict policy on early repayment. Unlike invoice factoring, which clears your obligation when your customer pays their balance, term loans are essentially set in stone.
Whether you have the money or not, you’re expected to make payments on or before the due date. If this repayment rigidity is a deal-breaker for you, consider merchant cash advances (MCA). Instead of a fixed repayment schedule, you remit payment for an MCA based on the volume of your credit or debit sales. That way, your payments increase when sales increase and decrease when sales slow.
2. Stringent eligibility requirements
For any small business lender offering a loan, the borrower’s credit risk is the most important factor to consider. Plus, because term loans are typically for larger amounts, the downside is significant. To account for this risk, working capital lenders enact
strict eligibility requirements.
Typically, online lenders have less stringent criteria than traditional banks, but in either case, you’ll need an excellent credit history to qualify. If you don’t already have a credit score above 600, you’ll need to build your credit before you start applying for a loan.
3. Potentially slow funding time
The business loan application process alone can take weeks to fully unfold on a term loan. After that, the business lender has to complete many other internal processes that can delay the funding of a term loan. In some cases, it can take a few business days, but some financing lenders have a longer qualification process.
Therefore, in many cases, this type of loan may take a long time to fund, depending on the lender you select. However, you can avoid this slow funding by researching alternative lenders that make term loans.
Conclusion: Find Your Preferred Type of Term Loan
While the pros and cons listed above apply generally, there’s a lot of variety among term loans. For example, online lenders approve term loans more often and fund them quicker compared to banks or credit unions. At the same time, online lenders tend to charge higher interest rates than banks or credit unions.
The point here is that not all term loans are created equally. The amount, length, type of lender, and other details significantly affect a term loan’s eligibility criteria, cost, funding speed, and repayment schedule.
Therefore, if you’re considering a term loan, do your research about the specific type of loan and lender you’re looking for. Otherwise, it’ll be difficult to do a fair comparison of the different loan rates, terms, and conditions that you find.