How to Choose the Best Loan Term for Your Business
What Loan Term Is Right for Your Business? The key is to borrow enough - but not so much that you can't pay it back.
So, you’ve decided to take the next step with your business and will apply for a loan to help get you there. While there are a few things you have no control over with the process, one big one is pretty much up to you: the term of the loan, or in other words, how long it will be from when you get the funds to when you pay it off.
The lending industry classifies loans by their duration: short, medium and long-term loans, and different time frames work better for different businesses and distinct situations. If most of your experience with loans is from mortgages, you’ll need to readjust your thinking a bit. While long-term mortgages can be thirty years or longer in length, long-term business loans generally run three to ten years, although longer terms are possible. Medium or intermediate-term loans generally take from one to three years to mature, and short-term loans are usually one year or less in length.How do you know which one is best for your needs? Let’s see what each does best.
As we said, these loans are generally repaid within a year, making them ideal for businesses that need a cash infusion to help with an immediate need, one for which you expect to recoup the money quickly. For example, perhaps you have a retail business and need to order holiday inventory. It’s summer and cash flow is a little slow, but you know your back-to-school and winter seasons will be strong. A short-term loan can help you build your inventory for those busier times to come. Another benefit of short-term loans is that they can help you build your credit and help you qualify for larger, longer-term loans in the future. As with your first personal credit card, you initially got approved for a small line of credit that slowly increased as you paid it off and proved you were a good risk. Similarly, a short-term loan is a good way to establish a relationship with a lender. Short-term loans generally have higher approval rates because there is a greater chance they will be paid back. Depending on your qualifications, they are less likely to have to be backed by collateral.
Medium or intermediate-term loans generally have a length of one to three years and are usually used for expenses like computer systems or other assets that will last just a few years, rather than long-term assets like buildings. These items, like equipment, machinery or commercial vehicles, are called capital expenses and are not every-day operating costs. Dollar amounts are usually greater than for short-term loans, and the approval process is even more stringent. Medium-term loans are virtually always secured by collateral and a personal guarantee.
Long-term loans usually mature in three to ten years, although they can be negotiated for longer. These loans are always supported by collateral, whether it be a company’s building, equipment, inventory, or a mix of all of the above. As a rule, they are the toughest type to qualify for, and they also may have conditions attached about how the business must conduct itself going forward. These are known as restrictive covenants. The most common restriction is that the business may not borrow money from another lender during the period of the loan, but you will likely also be required to submit ongoing financial statements and other information about the business. As a general rule, experts suggest tying the length of the loan into the projected life of what you’re intending to use it for. In other words, a large, commercial printer in need of a new printing press might decide on a long-term loan to finance the purchase. You’ll usually be asked for a substantial down payment on the loan, typically 20%, to 25%, or more. Keep in mind that business loans are often structured with balloon payments at the end, meaning you pay back the interest and principal at an agreed-upon rate every month for the first few years, and then repay the rest of the balance in one large payment at the end. A longer-term loan may help you save up enough for that balloon payment, extending the amount of time until it’s due.
What Loan Term Is Right for Your Business
There is, of course, no one-size-fits-all answer to the question of which loan term is best for which business, but here’s a quick overview of some.
Loan Terms for Construction and Contractors
As the housing market continues to recover and grow, there is more year-round work in the building industry, but still, there can be slow periods. A short-term loan can help cover supplies and staffing until the business cycle picks up again.
Loan Terms for Seasonal Businesses
If you have a landscaping company, a retail operation that specializes in seasonal merchandise (pools, skis, a garden center), or a service business that ebbs and flows with the calendar (sprinkler repair and installation, snowplowing, etc.), you are the perfect candidate for a short-term loan.
Loan Terms for a Dental or Medical Practice
Buying a practice is something most medical professionals may do just once or twice in a lifetime, but it can take considerable funds to buy both a patient roster and offices. In most cases, a long-term loan will suit this best, while a shorter, intermediate loan might work for buying new, state-of-the-art equipment.
Loan Terms for an Import / Export Business
Businesses like this often rely on overseas connections that can be subject to economic or political uncertainty. Having money available to help get through unforeseen circumstances can be crucial in keeping things going. For these businesses, a medium-term loan can help you weather an unexpected storm until things calm down, or in good times, invest in emerging markets as they continue to grow and expand.
Loan Terms for Manufacturers
Companies dependent on larger factory operations and expensive, specialized equipment, are often candidates for long-term loans. Whether you need to buy a larger building or invest in the latest machinery, the outlay is probably fairly large, and you’ll need both time and income to pay it off.
Loan Terms for Professional Practices Such as Attorneys or CPAs
Similar to dentists and doctors, lawyers and accountants may also decide to buy or buy into a practice. They may also buy a building instead of leasing space from a landlord. These potentially expensive purchases lend themselves to long-term loans, while an outlay for new office equipment can likely be covered in a shorter period of time.
Loan Terms for Restaurants, Caterers, and Bars
Apart from a mortgage to buy land or property, food and beverage-based businesses are perfect candidates for short and medium-term loans. You need the proper equipment, inventory and staff to be successful, and a cash infusion can help you do that. Think short-term if you’re looking to fund a marketing campaign or training program, more toward an intermediate-term to replace old kitchen equipment or renovate your dining room.
Loan Terms for a Retail Business
In some industries, payments take longer than others. The garment business has a notorious lag between paying its suppliers and getting paid for goods. The same is true with many other businesses with seasonal inventory, and this can wreak havoc with cash flow. Short-term loans can help cover a temporary shortfall to meet payroll or other expenses.
Loan Terms for Startups
Fledgling businesses can find it very difficult to borrow money. Remember again back to your first credit card or car loan when you just got out of school. With little to no credit history, lenders are more reluctant to trust you with their money. While difficult, it is possible for startups to get commercial loans, and shorter-term loans will be the easiest to negotiate. Be prepared to provide a lot of documentation, including a strong business plan and projections for the next several years. You are also more likely to have to offer some sort of collateral to secure the loan.
Advice for All Term Loans
You’re in business to make money, as are the lenders you want to borrow from. That means it’s not likely you’ll be approved for more money or a longer loan term than you can feasibly handle but always err on the safe side. The key is to borrow enough so that your company can reach its potential – but not so much that you can’t pay it back.