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How long will you be paying back your small business loan?
Taking out a small business loan can provide many benefits to your business, including increasing working capital, building business credit history, and funding large purchases. The direct financial impact the loan will have on your monthly cash flow and financial health will depend on the type of business funding, the repayment terms, and the purpose for the financing. Most entrepreneurs that are considering financing options are looking for more capital to:
- Cover startup costs
- Purchase commercial real estate
- Buy inventory or equipment
- Launch a marketing campaign
- Hire additional staff
- Repair appliances, vehicles, and machinery
- Fund operating expenses when cash flow is short
Regardless of the reason youâre considering a business loan, itâs important to know how long it will take you to repay the debt. A loanâs repayment terms describe the amount of time from the initial funding by the lender until the final payment is made. Since there are several different loan programs and types of business financing available, there are no universal repayment terms that apply to every loan type. The length of time you will be required to make payments on your loan depends on the following conditions.
Type of loan
The type of financing you are applying for has the most influence on the repayment terms. For example, a commercial real estate loan for a new warehouse will require more loan payments than a cash advance taken out to repair a window. We describe several different types of loan options in a later section of this article, but most loans can be categorized as long-term or short-term loans.
- Long-term loans â Long-term business loans may have repayment terms up to 25 years. Examples include commercial real estate loans, SBA loans, and equipment financing.
- Short-term loans â Short-term loans typically have repayment periods of 18 months or less. Examples of short-term loans include merchant cash advances, bridge loans, invoice factoring, and business lines of credit.
Loans for small businesses can be issued by a traditional lender or an alternative lender. The financial institution that approves and issues your funds will ultimately determine the repayment terms of the business loan, based on their policies and the borrowerâs creditworthiness.
- Traditional lender â Banks and credit unions typically work out of a brick-and-mortar location. Traditional bank loans often offer more attractive interest rates, but typically have stricter eligibility requirements and a longer approval process.
- Alternative lender â Online lenders, or marketplaces, like Biz2Credit work to provide fast funding to approved borrowers. The loan application process is completed online and there are several financing options to choose from.
The interest rate on a small business loan will affect the total amount of money it will take to repay the loan in full. A higher interest rate means the cost of financing the loan is higher which will translate to higher monthly payments and a longer repayment term. Interest rates on business loans are either fixed or variable.
Fixed rate interest â determined at the time of approval and remains the same throughout the life of the loan.
Variable interest rates– Variable interest rates fluctuate throughout the life of the loan with the current market rate. The market rate used as a base for the interest payments will be identified in the loan documents and is usually based on the LIBOR or PRIME rates.
The reason that a small business owner seeks funding will factor into the repayment terms. For example, equipment loans have repayment terms that match the useful life of the purchased equipment, while loans approved for borrowers to cover startup costs may have shorter terms.
How are repayment terms determined?
Most borrowers want to get the best business loan terms possible, because that means they will repay the debt sooner and pay less in overall financing costs. Lenders also want their borrowers to get the best repayment terms because it minimizes the risk of default. During the underwriting process of a business loan, lenders determine the appropriate terms based on the creditworthiness of the borrower. Creditworthiness is determined by evaluating the following:
Even though it is the business seeking financing, new businesses, or those with incomplete or negative business credit history may need to rely on the personal credit score of the business owner. An individualâs credit score, or FICO score, is between 300 and 850 and calculated using factors like payment history, available credit, credit inquiries, and more. Small business owners with higher credit scores are more likely to secure a loan with better repayment terms.
Lenders will use the net income of a business to calculate risk and determine interest rates and other repayment terms. Businesses with a steady or growing net income can secure more favorable repayment terms than those whose net income has been declining. To evaluate net income and estimate an average annual business expense, underwriters will require two years of business income tax returns. For new business owners, individual tax returns may be used.
Business credit history is monitored by business credit bureaus. Sometimes called a PAYDEX score, it accounts for a businessâs open credit lines, payment history, and amount of time in business. Business credit scores range from 1 to 100, with higher scores having access to better loan repayment terms and vendor credit.
Lenders may use the businessâs financial statements, including an income statement, budget, and balance sheet to measure the companyâs ability to repay the loan. An income statement gives the annual revenue of the business and a snapshot of how much income is left over after expenses are paid (profit). For startup businesses or new entities, lenders may review the bank statements for the business checking account and the primary shareholderâs personal bank account as well. A business plan may also be reviewed by the underwriter to evaluate the businessâs goals and operational plans.
Availability of collateral or a personal guarantee
Borrowers that have bad credit or have not yet established good credit history may be able to be approved for a secured loan under the condition that they provide collateral, like a home, car, or piece of equipment. A personal guarantee may also be required which tells the lender that if the business defaults on the loan, the borrower will repay the debt with personal funds.
Can you change repayment terms?
The repayment terms of a business loan determine how long a borrower will be making payments to the lender, but repayment terms are not forever. It is possible to change the terms of your business loan after youâve already received funding from a lender. There are two common ways business owners can use to change the repayment terms of their loan.
Pay off the loan
One way to change the amount of time you will be paying on a loan is to pay the loan off early. Before considering this option, you should review the loan documents to learn if there is a prepayment penalty on the loan. Prepayment penalties are typically a percentage of the remaining balance or a predetermined amount of interest. These fees allow the lender to lessen the loss of future interest income when the loan is paid off early but are a disadvantage for the borrower. If the loan terms and your businessâs cash flow allow for prepayment, paying off the balance of the loan will end the monthly payment obligation.
Refinance the loan
A more common method of changing the repayment terms on a small business loan is through refinancing. The process of refinancing a loan requires taking out a new loan to pay off the existing debt. Refinancing a loan can be done through the same lender that issued the original funds or through a new lender. There are many benefits to refinancing business debt, including the following:
- Lower interest rates â As previously explained, interest rates are determined using the borrowerâs creditworthiness and external factors, like the market interest rate set by the Federal Reserve. You may qualify for a lower interest rate which will decrease the total financing costs on the debt if youâre credit or the market conditions have changed.
- New repayment term â A refinanced loan may allow you to extend the amount of time you will be making payments, lowering the monthly cash obligation. A new loan may also allow you to shorten the repayment term if the interest and other financing charges are reduced, so you could pay the loan off faster with the same monthly payment.
- Consolidation â Refinancing is a great financing option for borrowers that have multiple business loans or business credit cards. A new loan can allow borrowers to consolidate several debt payments into one monthly payment. Consolidating loans can simplify the monthly financial statements of the business and allow for a smoother budgeting and cash forecasting processes.
Types of business loans and repayment terms
Since so many factors go into determining the repayment terms of a loan, there is no list of set terms. However, the type of loan and the loan amount a borrower is approved for will have the greatest impact on the amount of time it takes to repay the loan. Some common small business loans include term loans, SBA loans, and business lines of credit.
A term loan is a traditional type of small business financing where the borrower receives a lump sum payment upfront and then makes payments on the loan according to the repayment schedule. Borrowers may be approved for repayment terms up to 20 years depending on the amount financed and the purpose of the loan. Term loans are issued by banks, credit unions, or alternative lenders, like Biz2Credit. Term loans can be used for short-term financing or long-term business needs. Term loans can be secured with collateral or unsecured loans, where the borrowerâs credit is enough to secure the loan.
SBA loans are financing options for small business owners where a portion of the funds are backed by the U.S. Small Business Administration. SBA loans are funded by approved lenders and the repayment terms depend on the loan program chosen, the purpose of the financing, and the borrowerâs credit. Some of the most common SBA loan programs include the SBA 7(a) loan and SBA microloans. The SBA 7(a) loans typically have repayment terms of 7-25 years and Microloans require repayment within 5 years.
Business line of credit
A line of credit is a type of revolving credit where small business owners are approved for a maximum credit line. The borrower can then draw on the credit line anytime they need fast funding. Monthly payments on lines of credit are calculated using the interest rate listed in the loan documents and the amount of credit currently withdrawn. The repayment term of business lines of credit is typically 3 to 5 years.
Business loan repayment can take a toll on a small business ownerâs monthly cash flow. Repayment terms, like the number of required payments and financing costs, can be changed if the borrower pays the loan off early or chooses to refinance the debt. Refinancing helps small business owners save money and simplify their business finances. One wholesale entrepreneur was able to refinance using their accounts receivable to change the payment frequency and access equity on their business loans when they turned to Biz2Credit for better repayment terms. In the long run, nearly every small business will utilize financing options at one point or another. The key to using financing successfully is to understand the terms of the loans you are considering and to only take out loans that make sense based on your most accurate revenue projections.