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About Term Loan

Term loan is also called as demand loan. A term loan is a funding from a bank for an amount that is to be repaid as per EMI (Equated Monthly Instalment) schedule. The interest rate can be either fixed or floating rate as per the choice of the borrower. Term loan can be extended for variety of purposes including setting up of business, working capital expense, purchase of equipment, overhaul of plant and machinery etc. The loan tenure can range between 1 year to 3 years to 10 years. The tenure may be extended on a case to case basis upto 30 years. Also, shorter-term credits can be extended for companies which need funds but do not qualify for longer term credit. Term loans are extended for both green field and brown field projects.

Term Loans
Term Loans

Types of Term Loans

Term loans can be categorized based on the tenure for which they are borrowed. The categories in general parlance are –

  • Short-term loan :
  • The loans are for less than a year or upto 18 months. These companies may also be ones that do not qualify for longer tenure of credit.

  • Intermediate term loan :
  • The period for such loans could vary from 2 year – 5 years. These loans could be critical for company’s cash flow. Typically, companies which are new and have established afresh may need such intermediate term loans.

  • Long-term loan :
  • These loans can run anywhere between 5 years – 10 years. The company’s assets are offered as collateral. The repayment could be either monthly or quarterly as per the company’s profit or cash flow recognition.

Short-term loans and intermediate loans are called balloon loans as they come with balloon payments. The final instalment is higher than the previous loan instalments. Since the instalments swell towards the end of the loan tenure, it is called as balloon loans.

Features of Term Loan

The key features of term loans are as follows –

  • Term loans are secured loans, the asset purchased will be collateral to the lender
  • At times term loans can also be unsecured, in which case the interest rate would be higher
  • Regardless of the financial situation of the company (borrower), the loan must be repaid over the fixed term
  • The proposal is evaluated for credit risk, loan amount and tenure for which the loan is taken and the interest rate on the loan will be adjudged
  • Rate of interest will be negotiated between the lender and borrower at the time of loan distribution
  • Term loans will have a tenure of 5 – 10 years, repayment is made in instalments
  • Tenure can be re-scheduled incase the borrower is in financial distress
  • Based on conditions, the term loan can be converted into equity holding
  • Defaults are subject to penalty levied by lender
  • Commitment fee is charged on the unutilized loan amount
  • Principal loan amount is repaid after the initial grace period of 1-2 years
  • Towards the end of the tenure, the installment is likely to have higher principal amount and lower interest amount

Pros and cons of availing Term Loan

There are advantages and disadvantages for a borrower who opts for term loan.

Pros

  • Term loans are negotiable, the interest rate, tenure, repayment schedule can be negotiated
  • Interest rate is lower than that of personal loan or any other type of business loan
  • Interest paid towards term loan is subject to tax deduction at the borrower’s end
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  • It is a secured loan, where the asset purchased is the collateral or any asset equivalent to the loan value is pledged as security – it is not a high-risk loan for the lender
  • Term loans do not dilute the equity for promoters and shareholders
  • Term loans can be converted to equity based on prior agreement, thereby making it an attractive preposition to the lender

Cons

  • On default, the collateral would be sold, and loan would be settled in full
  • Increases the leverage in the Balance Sheet substantially
  • Payment of interest towards loan reduces the net profit of the company
  • The lender is likely to impose restrictive covenants such as not increasing leverage, this potentially affects the firm’s functioning
  • Irrespective of the financial health and status of the company, the repayment must be as per schedule
  • Negotiated terms may not necessarily be in favor of the lender
  • In the event of default, the lender may call for conversion of outstanding debt into equity, thus diluting the holding

Factors that determine the Term Loan eligibility

The factors that affect the eligibility to avail term loan are -

  • Promoters background – The background and credibility of the promoters is evaluated. The higher the credit score of the promoters, the better are the chances for favorable negotiation.
  • Business plan – The business plan will be evaluated for financial viability and the capacity for loan repayment. Based on this critical evaluation, the loan will be extended. The quantum of loan and interest rate is determined based on this critical factor.
  • Operational performance – If the loan is sought by an existing business, their operational efficiency is evaluated. The operational profit is evaluated before sanction of loan.
  • Infrastructure – The infrastructure of the business is assessed to ensure that in case of default, the sale of infrastructure can close the loan in full. This factor is evaluated even though these loans have collateral equivalent to the loan extended. This is also critical when the term loans are extended for business expansion, wherein there is no underlying asset. The loan is against existing infrastructure.
  • Collateral security – This is one of the most critical factors for eligibility of term loan. Term loans are extended for a variety of purposes such as purchase of equipment, plant and machinery etc. In such cases, the asset itself is the collateral. In cases where the loan is extended for business expansion, achieving economies of scale etc., the collateral must be evaluated appropriately.
  • Credit repayment track record – The credit repayment track record of the business entity is traced. The better the credibility, the terms will be more favorable.
  • Present and projected financial performance – the existing financial performance is assessed. The business plan also has financial performance projected over the next 3 to 5 years. Prospects in terms of financials is assessed by the lender.

Floating rate and fixed rate of interest

The interest on the term loan can be either floating rate or fixed rate. Normally, the borrower has the discretion to choose between the two.

Floating rate of interest :

The interest rate pertaining to the loan fluctuates with the market interest rate and economic conditions of the market. This inturn causes the instalment amount to change over the tenure. Typically, banks revise the rate of return every few years or align themselves with market subject to severe or drastic change thereof.

Fixed rate of interest :

The interest rate pertaining to the loan, in this case, remains fixed over the tenure of the loan. The installment amount remains constant over the tenure. The rate of interest is decided upon at the time of loan sanction.

The borrower can choose the type of interest rate based on the market cycle. Typically, when the interest rates are high, one chooses the floating rate of interest, in the anticipation that the rates may moderate over the next few years. When the rates are lying low, it makes sense to lock-in with fixed rate of interest. Also, typically, fixed rate of interest is chosen for short-term loans and for long-term loans floating rate of interest is preferred.

Term loans are ideal for any asset purchase, business expansion or asset overhaul, the terms can be negotiated favorably depending on the credit history of the business.

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