Business planning entails looking for new growth opportunities. These opportunities usually require an investment in something to generate higher returns. It could be an investment in real estate, new equipment, or hiring more employees. Companies in their early growth phase especially need to invest in these opportunities. They may, however, not have easy access to funds for the same. Term loans are among the popular long-term financing options. They could be floating or fixed interest rate loans. They come with various repayment schedules and loan terms. Continue reading to learn more about understanding debt repayment agreements in detail.
What is a Term Loan, and How Can it Help Your Business?
A term loan is a loan where the borrower obtains a lump sum of money in exchange for repayment at a predefined interest rate, usually in instalments. The period of repayment is usually between 1 and 25 years. Loans with a repayment schedule shorter than a year are called short-term loans. A business term loan is typically granted based on good financials and creditworthiness.
A term loan could be beneficial to a business in the following ways:
Access to funds for investment: It gives the business access to a large number of funds at once, which it can use to fund expansion or growth.
Working capital needs: Working capital requirements, such as buying inventory, raw materials, etc., can be managed through loans.
Refinance older debt: The funds can be used to refinance previous debt at a cheaper price if the business has become eligible, or for better liquidity.
Convenient debt repayment agreements: The repayment period and instalment size are negotiable at the borrower's convenience.
Better financial indicators: Debt increases the return on equity for shareholders.
Understanding the Different Types of Term Loans Available
Term loans are usually classified as intermediate and long-term loans based on the period of repayment. Intermediate-term loans have a tenure of 1 to 5 years, while long-term loan tenures can usually go up to 25 years.
Other types of term loans include:
Start-up Loan: The start-up loan is a great business finance option for new ventures that have established businesses. In these loans, the lender looks at the creditworthiness of the applicant along with that of the company. They require proof of the existence of the company in the form of registration. The interest rate, tenure, and amount to be loaned are decided based on cash flow statements and other turnover-related figures.
Business Loan for Women: Many financial institutions have separate loan schemes for women entrepreneurs. These usually offer better loan terms to women-owned small and medium-sized enterprises to encourage social and financial equality.
Equipment Financing: Various businesses, such as manufacturing companies, require financing for expensive equipment used in production or other value chain activities. Loans to finance this purchase are usually at a lower interest rate as compared to other business finance options.
Loan against property: It is also possible to avail of a term loan by using commercial or residential property as collateral. Usually, a loan amount of up to 70% of the property can be obtained; however, this might vary from lender to lender.
There are other short-term loans to meet working capital needs, overdraft facilities, and invoice financing that can be availed of to meet liquidity needs. These loans may charge interest based on a base rate, such as a repo rate plus something. These loans could also be fixed interest rate loans. If the interest rates are expected to decrease, it is better to take a floating-rate loan; otherwise, a fixed-rate loan is a cheaper option in the long run.
Choosing the Right Type of Term Loan for Your Needs and Goals
A term loan agreement may consist of a single payment of the loan, where one can pay interest periodically and repay the entire principal in a bullet repayment at the end of the term. On the other hand, it could take the form of Equated Monthly Instalments (EMI), in which one can repay the loan in equal instalments.
Here are some recommendations that can be followed while negotiating a term loan structure:
Understand the gap in funds
One must understand what sort of gap in funds one is facing. For example, if the account receivables take a long time to turn over in comparison to the account payables period, it would require a short-term loan. Similarly, if funds are required to finance equipment and hire more employees, an intermediate-term loan would be best for the business.
Evaluate the cost of financing
Unsecured loans come with high-interest rates; secured loans are cheaper. Also, the cost of a loan includes various fees, such as the origination fee, processing fee, prepayment fee, document processing fee, and post-dated cheque charges.
A lender might charge all or some of these while giving out a loan. One must factor in these charges when evaluating the overall cost of funds for the business.
Examine the repayment terms
One must carefully understand the repayment terms of the term loan agreement, such as tenure, instalment frequency, EMI bounce fee, prepayment penalties, etc. Because the loan will be repaid with cash flows from the business, cash flow expectations must be carefully aligned with the planned instalment size.
What are the Pros & Cons of Taking Out a Long-Term Loan?
Let's evaluate the pros and cons of taking a term loan:
Pros
Cons
A term loan allows one to negotiate favourable repayment schedules.
Any default on EMI can lead to an EMI bounce fee.
It helps build a good credit profile for the company if the loan is repaid as per the schedule.
Early payment of the loan might come with prepayment penalties.
The interest rates for term loans are relatively lower than those for short-term loans and other overdraft facilities.
The repayment schedule is generally inflexible, and in lean business periods, it could be a burden to track payments.
It makes funds accessible in a lump sum amount, which can be repaid as per financial capacity.
The eligibility conditions for a term loan for a business are very stringent.
How to Create & Implement a Reasonable Repayment Plan for Your Business’s Term Loan
Here are some of the recommendations one can follow to implement a reasonable repayment schedule:
Use the extra cash to pay more than EMIs: Use any extra cash one might earn to repay the term loan. One must take prepayment fees into account as a part of the loan terms and ensure that the interest one saves by early repayment of the loan is greater than the prepayment penalty that one might have to pay. It is essential to track payments and ensure that no late fee is paid.
Increase EMI periodically: One can negotiate terms that allow one to modify the EMIs at periodic intervals. This will also enable one to pay off the loan ahead of schedule.
Enable auto-pay settings: It is convenient to set up instalment autopay to ensure that no instalments are missed. This will save one from having to track payments and also ensure that the credit score remains good and one does not end up paying any EMI bounce fees.
Conclusion
Term loans offer an excellent long-term financing option for a venture. Before taking out a term loan, it is critical to understand one's requirement gap and project future cash flows reasonably. Also, one must carefully evaluate the loan terms to chalk out a convenient repayment schedule. Further, one must ensure that they track payments continuously so that they do not have to pay a late fee or ruin their credit score for future financing. Tata Capital Term Loans offer opportunities to customise a repayment schedule as per one's requirements.
21 February 2023
7 mins read
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