What is a term loan? (Explained)

Banks issue term loans to the public in exchange for specific borrowing terms and conditions.  The repayment schedule of term loans is usually long term i.e.,  more than  1 year. Term loan carries fixed or floating interest rates and the mechanism of distribution of funds is similar to lines of credit. Businesses use the facility of term loans to draw funds when needed and pay the interest on this loan based on the remaining balance.

Term loan for business

Small businesses can apply for term loans if they have sound financial statements. Lump-sum cash upfront is paid to the borrower if he agrees to the repayment schedule and rate of interest. However, the terms of this loan may require a substantial down payment to be made after a certain time. This will not only reduce the payment amounts but will also reduce the overall total cost of the loan.

Borrowers prefer terms loan because of:

  • Low-interest rate
  • Convenient application procedure
  • Specified payments
  • Lump-sum cash upfront
  • Companies frees-up their own cash to use on any other project by taking term loans.

Feature of term loan

The main features of term loans are described below for ease of a borrower’s understanding.

  • Amount of term Loan

Terms loans usually come with a fixed loan amount. The value of a loan may vary based on the type of loan chosen.

  • Repayment Time

Term loans are repaid in a specified time as agreed under the terms while availing this loan. The duration of repayment determines whether it is short, mid, or long term.

  • Collateral Requirement

A term loan may or may not require collateral to determine whether it is secured or unsecured.

  • Interest rates

The interest rate charged on term loans can be Fixed or Floating. A borrower is given a choice to either opt for a fixed or floating interest rate.

  • Fixed repayment schedule

The borrower has to repay the substantial principal amount along with the interest component based on a repayment schedule.

Term loan example (Usage perspective)

Businesses who want to meet their day-to-day expenditures can opt for working capital Loans. These loans are classified as short-term loans.

Equipment financing loans are available to businesses and enterprises who are interested to invest in purchasing equipment or vehicles

Term loan A vs. B

Term loan A is also known as senior term loan. It generally matures within 5 to 6 years. Term loan A is amortized over a period and the borrower has to repay yearly, an amount falling between the range of 5% to 20% of the initial principal loan. Banks are the lenders of term loan A.

Term Loan B.is also referred to as an Institutional Term loan. The main intention behind issuing a term loan B is to maximize their long-term total returns on investments. Their maturity date falls between 6 to 7 years. Such loans usually have a schedule of small repayment( e.g., only 1% of the principal amount of loan is repaid each year) and the remaining amount is due at maturity.

A prepayment of term loan B may penalize a party if payment is made within a year. The interest rate margin is usually higher in the case of term loan B than the interest margin on term loan A. 

Term loan vs. overdraft

OverdraftTerm loan
It is a facility by which customers can withdraw funds from their current accounts even if the balance is zero.It offers a fixed amount to be borrowed against conditions of fixed or floating interest rate along with substantial principal repayments.
Overdrafts usually don’t require security or collateral. Although, sometimes it may require collateral in the form of fixed deposits.It can be secured or unsecured.
They are short-term loans.Term loans can be short, mid, or long-term.
The repayment of overdraft is made through bank deposits.In the case of term loans, repayment is either in form of installments or on-demand.
Banks do have a right to change the credit limits of the customers. So, the amount can be withdrawn within a limit.The amount once fixed for the term loan can not be modified.

Difference between a term loan and demand loan

  • In case of a demand loan, the lender may ask the borrower to repay the amount in full at any time. Whereas term loans have no such strict conditions. Term loans are repaid according to the repayment schedule and it has a specific length of time.
  • The tenure of a term loan is usually more than 1 year. In comparison, the demand loan is of a short-term nature and its period ranges from days to a few months.
  • The borrower is required to pay a penalty in case of repayment of the term loan before the maturity date. There is no such prepayment penalty in case of a demand loan.
  • The main reason for obtaining a term loan.is to start a new project, purchase machinery, land, plant, land, or expansion of business, etc. However, demand loans are more preferably used for the purpose of purchase of small equipment, raw materials, or for the payment of short-term liabilities, etc.

Also read, Internal source of finance

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