Term loans explained: How they work and when to use one

If you’re looking to borrow funds to launch or expand your business, a term loan could help you reach your goal. Here’s how they work.

Key takeaways

• A term loan is a business loan that you repay over a specified period (the ‘term’)

• Loan terms range from a few months to several years

• Some term loans require collateral, while others don’t

• You can use a term loan to expand your business, pay for inventory or cover bills

What is a term loan? 

A term loan is a type of business loan that you must repay over a specified period, known as the term. Depending on the type of loan, the term could be anywhere from a few months to 25 years or more.

Your business borrows a lump sum of cash that it then repays in monthly instalments. Each repayment comprises a portion of the amount borrowed plus interest, and by the end of the term, the loan is repaid in full. 

Term loans can have fixed or variable interest rates. If the rate’s fixed, you know exactly how much you need to pay back each month, helping you to budget. However, if the rate is variable, your monthly repayments may change over time. 

How can a small business use a term loan?

You could use a term loan to help you fund any of the following:

• New business premises

• Inventory and stock

• Staff wages

• New equipment

• Renovations

• Bills

You could also use a term loan to consolidate existing debt. 

What are the different types of term loans?

When comparing term loans, you may come across the following types:

Short-term loan

As its name suggests, a short-term loan has a brief repayment period, typically one or two years, or even just a few months. A VAT loan, for example, is a type of short-term loan repaid over three to 12 months. 

Although VAT loans are a type of secured loan, many short-term loans are unsecured business loans, meaning you won’t need to use an asset as collateral. However, this usually results in higher interest rates. 

Medium-term loan

A medium-term loan has a repayment period of around two to five years. Interest rates tend to be more competitive than short-term loans, and they are typically unsecured. You can also borrow larger amounts.

Long-term loan

Long-term loans let you repay the borrowed amount over an extended period, up to 25 years. They allow businesses to borrow larger sums, making them useful for buying property or investing in equipment.

As this type of borrowing typically falls into secured business loans category, you must provide an asset, such as property or a vehicle, as security. This reduces the lender’s risk, often leading to lower interest rates. However, your asset is at risk if you can’t repay the loan.

Advantages and disadvantages of term loans

As with most types of business finance, you need to weigh the pros and cons before applying.

Pros

• Fixed repayment term: You know exactly when the loan must be repaid. If your loan has a fixed interest rate, monthly repayments stay the same, making budgeting easier.

• Builds business credit: Repaying your loan in full and on time helps improve your business credit score, making it easier to access future credit.

• Long repayment terms available: Spreading repayments over several years can help manage cash flow.

• Freedom to use funds as you wish: A term loan offers flexibility. You can use it for almost anything – whether you’re buying premises, hiring staff or launching new products.

Cons

• May require collateral: Some term loans require you to use an asset as collateral. You could lose this asset if you fail to make your repayments on time

• Harder to qualify: You may find it harder to qualify for a term loan than other types of business finance if you have a poor or limited credit history 

• Less flexible: Although fixed monthly repayments provide stability, they don’t provide leeway if you can’t make a payment one month

How to choose the right term loan for your business 

If you’ve decided to apply for a term loan, make sure you consider the following questions before applying: 

• Why do you need the loan? Are you covering short-term expenses like bills, or funding a long-term project like buying premises?

• What’s the interest rate? Check how much interest you must pay overall and whether it’s at a fixed or variable rate

• Are the repayments affordable? This is crucial. Make sure you know exactly how much you have to repay and by when, and put a repayment strategy in place. You can use our loan repayment calculator to help you plan 

• Do you need collateral? Find out if you need an asset as security and think about whether you’re comfortable with that

• Are there any fees? Some loans charge an arrangement fee, while others apply early repayment penalties 

Who qualifies for a term loan?

Businesses with a good credit history and strong cash flow have a better chance of qualifying, as lenders see them as lower risk.

A limited credit history won’t necessarily prevent approval, but it may result in a higher interest rate or a lower loan amount.

Find out more in our how to get a business loan guide.