Term loans demystified: How they work, when to use them, and what to avoid

Financial needs often arise in the form of money for businesses, and individuals are required to have immediate working capital, make large purchases, and undertake expansion projects. Perhaps the most popular source of funding is via term loans. This article will help you make informed choices as it elaborates on the features, benefits, and drawbacks of term loans.

Understanding term loan

This is a loan given to an individual or firm for a fixed duration. Term loans can be for capital expenditure, the purchase of equipment, or for business expansion purposes. Term loans provide easy access to funds through simplified documentation, speedy disbursement, and flexible repayment plans.

What are the interest rates on term loans?

Interest rates on term loans in India typically range from approximately 9% to 17% per annum, with variations depending on the borrower's credit profile, loan tenure, type of collateral provided, and the lending institution's policies. Generally, secured term loans (those backed by collateral) offer lower interest rates than unsecured loans because they present less risk to the lender.

Still, for complete details on the term loan offered to you, along with other applicable terms and conditions on a case-by-case basis, consider reaching out to your respective lending financial institution.

Note: The interest rate range discussed above is illustrative in nature. For the updated rates, terms, and conditions, refer to the official website of your respective lending institution.

Types of term loans

1. Short-term: For periods ranging from 12 to 18 months, these types of loans are specifically designed to meet the urgent cash flow requirements of firms.
2. Intermediate-term: Most suited for any firm seeking provision of finance on a medium-term basis, this type of loan allows for repayment periods not exceeding 96 months.
3. Long-term: For making significant investments, these loans are the most suitable because they have long payback periods and consistently offer competitive interest rates.

Benefits of a term loan

• Predictable payments: Fixed monthly payments lead to better budgeting and financial planning.
• Long-term financing: Long repayment periods allow the business to invest in growth without it being financially overwhelming.
• Lower interest rates: Interest rates are generally lower than those for other short-term financing options and other personal loans.
• Versatile usage: Funds can be utilised to pay off existing debts, purchase equipment, meet working capital requirements for general growth and development, etc.
• Credit building: Repaying a term loan on time enables the borrower to build a better credit profile for future borrowing opportunities, making it highly useful in securing future loans.

How does a term loan work?

1. Fixed loan amount: The loan amount is fixed, depending on the loan type selected and the borrower's financial profile.
2. Structured repayment period: Stipulated for a fixed period of time from the date of borrowing.
3. Secured vs. unsecured: Term loans can be either secured (requiring collateral) or unsecured, depending on the borrower's eligibility, the amount to be borrowed, and the type of loan.
4. Interest rates: Borrowers can choose between a fixed or variable interest rate, depending on their financial preference.
5. Payback plan: It is mandatory for all term loans to have a clearly defined payback plan, by which the borrower makes timely EMI payments.

Drawbacks of a term loan

• Increased risk of default: Borrowing on uncertain terms raises questions regarding the financial health of the debtor company and complicates the case in the event of default.
• Debt: More debt increases the firm's financial obligations and makes it impossible to pay dividends on the shares.

In conclusion, they require strict adherence to the repayment schedules, which may become difficult in the event of sudden financial difficulties. Interest rates may remain high due to the size of the loans involved and the dire consequences that accompany loan repayment defaults.

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