Short or long terms. Fixed or flexible rates. Bank funded loans or alternative lenders. In the world of small business loans, there is a wide array of options available.
Today we’ll look at the three most common types of term loans—what they are, and the pros and cons of each. Not every loan type is the right fit for every business need, so read on to consider what kind of term loan would be the best fit for you:
If you’re looking for a little extra cash to meet a short-term financial need for your business, a short-term loan may be the right fit for you.
As the name implies, short-term loans are designed to meet short-term financing needs. Short-term loans are an incredibly versatile financial tool, offering business owners the chance to better manage cash flow, deal with unexpected needs for extra cash, and take advantage of new business opportunities that may come along.
For example, maybe you have an option to purchase extra inventory at a discount, but don’t have the cash on hand to purchase ahead. A short-term loan can offer you the financing you need to take advantage of that business opportunity and reduce your inventory cost.
One major benefit of a short-term loan is timing. Since these loans require limited paperwork, you can gain access to funds quickly to meet your business needs—with many alternative lenders advertising cash in hand in as little as two days.
As opposed to other loan types which may limit use of funds, short-term loans can be used for virtually any business purpose. And because the loan term is relatively shorter, you can limit how long the debt is on your books, impacting your bottom line of monthly profits.
There are some downsides to taking on a short-term loan. By tying up your credit with one of these smaller loans, you risk limiting your access to a larger or longer-term loan for another business need, such as purchasing property.
Typically, shorter term loans have higher annual percentage rates (APR), meaning you’ll be paying more in interest month to month than you would be with a longer-term loan. These loans also often require collateral in order to guarantee the loan.
A traditional term loan is the easiest to understand, because its probably what you naturally think of when you think of a business loan. The terms are pretty simple—you borrow a fixed amount of money, usually for a specifically stated business purpose—and pay back the loan over a fixed term and typically at a fixed interest rate.
If you’re looking for a loan with a fixed interest rate and predictable monthly payments that can be used for a wide range of business purposes, a traditional (or medium) term loan may be the right fit for your needs.
Another upside of a traditional term loan is that—as long as you consistently make your loan payments on time, it can help to improve your credit score—improving your candidacy for other types of business credit in the future.
Do keep in mind, though, that repayment periods aren’t the only longer term aspect of a traditional term loan. The application process can be much longer as well.
Depending on the institution, it can take several weeks or even months for a traditional term loan application to be satisfactorily completed, processed, approved, and funded. And once your loan is funded, it may include terms and interest rates that are less flexible than with other types of loans.
Prepayment penalties are another downside particular to traditional term loans. If your loan has a prepayment penalty clause, you’ll be charged a fee in the event that you decide to pay off your loan early. This can be frustrating for business owners once they’ve established themselves financially and have the cash on hand to get out of debt, only to realize that they’ll be penalized for doing so.
Like short-term loans, traditional term loans may also require collateral depending on your credit and financial situation.
The Small Business Administration (SBA) is a federal agency that helps entrepreneurs grow their small businesses by offering business education, connecting business owners with contracting opportunities, and facilitating access to small business loans.
Don’t misunderstand—although the SBA helps to make loans available to small businesses, the agency itself does not directly lend funds. Rather, the SBA acts as a guarantor of certain bank loans, guaranteeing a certain percentage of the loan in an effort to incentivize banks and special SBA lenders to lend money to small businesses. Because of this guarantee, banks can afford to offer lower down payments, longer payment terms, and more reasonable interest rates than with other types of term loans.
The SBA has several loan programs available, tailored to particular small business which may not otherwise be easily served in the commercial lending marketplace. Their most popular program is the SBA 7(a) loan program, which can be used for a variety of general business purposes. The Certified Development Company (CDC) 504 Loan Program is tailored for entrepreneurs seeking to purchase major fixed assets such as manufacturing equipment or commercial property.
The SBA Microloan program is a great fit for businesses in need of a relatively small amount of capital—$50,000 or less, as the program makes available through intermediaries loans that would typically be considered too small to serve by most commercial lenders.
Through their various loan programs, the Small Business Administration often gives special consideration to women and minority business owners, helping these entrepreneurs finance a wide variety of business needs. SBA loans can be used for adding to working capital, refinancing other debts, buying real estate, or even financing the acquisition of other businesses.
Because SBA loans must be approved by both the Small Business Administration and the lending institution, these applications involve the most paperwork and longest approval times of any term loan—often taking months of processing time before entrepreneurs actually have cash in hand. So if you need quick access to cash, the SBA loan requirements are likely to make this not the best choice for your business. But if you’re looking for the best available long-term financing, the low interest rates associated with an SBA loan may be worth the wait.
Remember, every business and every financial situation is different, so it’s worthwhile to seek advice directly from your lender or financial advisor to help you determine exactly which loan type will be the best fit for your company’s particular needs.