What it means
A term loan has four moving parts: the principal advanced, the interest rate, the repayment schedule and the security. Agree those four and you know exactly what the loan costs and when the cash leaves the business.
Companies use term loans when the spending is one-off and long-lived, such as buying equipment, fitting out premises or funding an acquisition. Matching a long-lived asset to a long-dated loan keeps repayments broadly in step with the cash the asset generates.
Most term loans amortise, meaning each instalment covers the interest due plus a slice of the principal. Early payments are interest-heavy and later ones are principal-heavy, which is why settling a loan halfway through its life does not halve the total interest cost.
A common variant is the bullet or balloon structure, where instalments cover interest and only a little principal, and a large final payment settles the rest. It keeps monthly outgoings low but creates a refinancing event that has to be planned for years ahead.
Term loans nearly always carry covenants: promises about leverage, interest cover or minimum cash that the borrower must keep. Breaching one can make the whole balance repayable on demand even if every instalment has been paid on time.
The rate may be fixed or floating. A floating rate moves with a reference rate, so a business with thin margins often pays a little extra for a fixed rate or an interest rate swap in order to make its cash forecast predictable.
In practice
Real-world examples
Example 1
A dental practice borrows $220,000 over seven years to buy two new surgery chairs and refit a treatment room. The monthly repayment is deliberately set below the extra fee income the third treatment room is expected to produce.
Example 2
A logistics firm takes a $3 million term loan over five years with a $1 million balloon at the end. Management plans to refinance the balloon against the depot it bought and diarises the decision for month 42 rather than month 58.
Example 3
A software company breaches its interest cover covenant in a weak quarter despite never missing a payment. The bank waives the breach for a $15,000 fee and tightens the reporting schedule from quarterly to monthly.
Think of it
A term loan is like buying a car with a bank loan. You get the keys to the vehicle right away, but you agree to pay the bank a fixed amount every month for the next three or five years until the debt is fully cleared.
Formula
Calculation
The instalment on an amortising term loan is: payment = P x r / (1 - (1 + r)^-n), where P is the principal, r is the interest rate per period and n is the number of periods.
A bakery borrows $500,000 over 5 years at 6% a year, repaid monthly. The monthly rate is 0.06 / 12 = 0.005 and the number of payments is 5 x 12 = 60.
The numerator is $500,000 x 0.005 = $2,500. For the denominator, (1.005)^60 = 1.348850, so (1.005)^-60 = 0.741372 and 1 - 0.741372 = 0.258628.
The monthly payment is therefore $2,500 / 0.258628 = $9,666.40. Over 60 months the bakery pays $9,666.40 x 60 = $579,984, so the total interest is $579,984 - $500,000 = $79,984.Case study
Seen in the real world
The following is a fictional, illustrative case. Marlowe Coatings, an invented industrial paint manufacturer, borrowed $800,000 on a three-year term loan at 7% to buy a mixing line with a twelve-year working life. The monthly repayment worked out at about $24,700.
The new line added roughly $18,000 a month of contribution, so for three years the loan was set to drain about $6,700 a month more than the asset earned. Marlowe covered the gap from its overdraft, which was expensive and left no headroom when a large customer paid late.
Two years in, with about $285,000 still outstanding, the company refinanced the balance over five years at the same rate and the payment fell to roughly $5,650 a month. The illustrative point is not that the original loan was mispriced, but that its term was mismatched to the life of the asset it funded.
Watch out
Common mistakes
- Matching a long-lived asset to a short loan term, which starves cash flow even when the underlying investment is sound.
- Comparing loans on the headline interest rate alone while ignoring arrangement fees, early repayment charges and covenant conditions.
- Assuming that reaching the halfway point of the term means half the interest has been paid, when amortising loans front-load interest.
Questions
People also ask
What is the difference between a term loan and a revolving credit facility?
A term loan is drawn once and repaid to a schedule, while a revolving facility can be drawn, repaid and redrawn again up to an agreed limit.
Can a term loan be repaid early?
Usually yes, but check the early repayment charge; fixed-rate loans often carry a break cost reflecting the lender's own funding position.
What security do lenders normally want?
For a business term loan, typically a charge over the asset being funded plus a general charge over company assets, and for smaller companies often a personal guarantee.