Applying for a Small Business Term Loan Explained

At workWhen most people are in the market for a small business loan, they think of a three- to five-year term with monthly payments. The problem with the business lending industry is that many business lenders are offering bad credit business loans. Small business term loans are very different from what the majority of the industry offers.

If you’ve ever had an auto payment or mortgage, you’ve had at least one type of term loan. That would fall into this monthly-payment-with-interest type of situation. A business would normally use a term loan when they need to finance the purchase of assets. For instance: equipment, inventory, expansion or a vehicle.

How term loan payments work

Term loan lenders look at debt service coverage, business financials, time in business and FICO score to determine who to lend to. This is the first step. The minimum guideline for a simple interest loan with monthly payments is two years in business.

The next thing they will look at is debt service coverage. Debt service coverage is a ratio that shows your profit compared to your expenses. A debt service of a 1.00 means that for every $1 dollar your business earns, you also spend $1 dollar. A debt service of a 1.10 means that for every $2 dollars your company earns you spend $1 dollar. And a debt service of a 1.20 dollars means that for every $3 dollars your company earns you spend $1 dollar. A business needs to have a minimum debt coverage of 1.00.

Then the lender will look at your business financials. Typically you’ll need three years of tax returns (or interim profit and loss statement if you’ve been in business two years), the most recent six months of business bank statements and one year of personal tax returns.

Lenders look at your personal FICO Score next. Typically, you need to have a 650 or higher to access a small business term loan. There are some extenuating circumstances where you can fall to a 620 with positive compensating factors like time and business margins.

Term loan interest rates and fees

With a term loan, you’ll be charged interest on the amount you borrow. The interest rates vary based on the current rate, use of funds and the perceived risk as evaluated by the lender.

The interest rate you’ll be offered depends on a variety of factors. Typically rates are 5.5 percent to 15 percent APR, but many things can affect that. Lenders take into consideration some particulars of the business such as the time in business and the industry.

In addition, lenders typically look at the debt service ratio, the increase in sales, and your cash flow management of the business.

Term loan approval rates

The Small Business Administration (SBA) offers several term loans as well as alternative lenders. According to Entrepreneur, SBA approval rates are significantly less due to the due diligence the SBA requires for its business owners and their business. This is highlighted by the fact that the SBA is only responsible for 21 percent of term loans as opposed to 61 percent in the alternative lending space.

If your business meets the minimum requirements for a term loan including FICO score, debt service coverage, financials and time in business, approval rates are as high as 85 percent.

Closing fees

As with most loans, there are closing fees involved. On small business term loans, you typically see three points on a loan that are taken out of the net proceeds. For example, if you borrow $100,000 you will usually net $97,000, but pay interest on the full $100,000.

Both traditional banks and alternative banks offer term loans. To give yourself the best shot at approval, contact a professional loan officer who offers multiple programs. They can tell you, based on your debt services and financials, which lender gives you the best shot at approval. Unless you’re in the industry, finding out all the caveats of the small business term loans can be a daunting task.

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