My daily commute is 45 miles each way, and the journey is littered with mortgage billboards. With interest rates at a generational low, homes are easier to buy than ever and almost everyone with an existing mortgage would be smart to refinance.
Term loans to buy a home are everywhere, but you rarely see ads for term loans for a business, although the loans function similarly, and the application process is almost identical. Let’s go through the basics of how small business term loans work and how to find one.
Overview: What is a business term loan?
Term loans are so-called because the loan amount is paid back over a specified term. This could be a fully amortizing term, meaning the loan balance is $0 at the end of the term, or the loan could be structured to make payments over the term with a big lump sum (called a balloon) due at the end.
Term lending is most often used to purchase real estate or equipment but you can also sometimes find short-term business loans to use for working capital or inventory purchases.
Types of business term loans
There are three main types of term loans:
Conventional is the fancy word for "you got it at the bank down the street." Conventional term loans have the easiest application process and are the cheapest. If you have a relationship with a bank already, you could likely walk into a branch today and start a loan application.
Conventional loans also have the harshest credit practices. Banks want to ensure that all of their loans are backed by strong collateral and are made to businesses with plenty of cash flow to pay them back.
The most common government-guaranteed loan type is an SBA loan. The Small Business Administration (SBA) has been around since the early 1950’s guaranteeing small business loans.
The SBA's mission is to provide additional security for conventional banks to allow them to make loans to small businesses that otherwise would not qualify for the loan. The government also has programs that make it easier to get term loans for women and other minorities and a microloan program for startup businesses.
There’s a wide variety of hard money loans. The loan can cover anything from purchasing real estate with a note from the seller to the type of back alley loan that may end up with you getting your legs broken.
Hard money loans are made based solely on collateral value. You go to a hard money lender and they value the collateral and lend maybe half of that amount. If you can’t make the payments, often with high interest rates, they repossess the collateral and collect their money that way.
For the most part, hard money loans are last resort loans. Use them only if you have no other option, or if you need a bridge loan to meet a financing deadline.
3 benefits of using a business term loan for financing
Here are the reasons to get a term loan.
1. Match cash payments with asset use
One of the key principles of accounting is matching. You want revenue and expenses to match in the period that they are incurred. When you buy big assets like real estate or equipment, we do this through depreciation expense, but the cash is all spent at once.
Using a term loan allows you to match your cash outflow with the use of the asset. It makes more sense to spend 1/300th of the cost of real estate each month (if you have a 25-year term) than it does to do it all at once.
2. Use leverage to buy more than you can with cash
Term loans also help you buy bigger assets than you’d be able to otherwise. If you have a quickly growing HVAC business with 15 technicians and 10 vans, you’ll need a place for them to park overnight and a shop to work on machines. Leverage allows you to own that shop and not have to throw money away on rent each month. The sooner you can buy real estate, the more value you gain long term.
3. Buy real estate to retire on
Business sales are volatile. If you’re planning to sell your business eventually and retire on the proceeds, be wary. Most banks don’t want to lend to business buyers if there are no substantial assets in the sale and underwriting standards are only going to get tougher in the future.
It’s better to plan to retire based on the strength of your business real estate. Most small businesses need a place to operate. Rent expense is a fixed expense — without it, the business would cease to exist.
If you use a term loan to own your real estate instead of renting it, you can secure your retirement without having to spend much additional money. You put up the cash to make the down payment and buy the building with a holding company. Going forward, your business still pays rent expense each month, but instead of going to a random landlord, it goes into your holding company to pay down the loan.
Once you’re ready to retire, you can still sell the business, but the amount of the business sale doesn’t matter as much because you’ll have income from the real estate with no loan payments left.
How to apply for a business term loan
Applying for a business term loan should work in much the same way as applying for a mortgage. Let’s compare the two processes. We’ll assume the business term loan is also used to purchase real estate.
1. Meet with your banker
If you’re buying a house, your real estate agent typically will recommend a mortgage broker, or you’ll go down to your bank branch and ask for someone to talk to regarding a mortgage.
With business loans, you often can get a pretty good recommendation from a commercial real estate (CRE) loan broker. Otherwise, you should start at your local bank branch where you have an existing relationship.
2. Prepare needs list items
For a mortgage, you’ll provide a few years of tax returns and IRS Form W-2s, a personal financial statement, verification of employment, and get your credit checked.
The commercial needs list is pretty similar, with a few more complicated items:
- Three years of tax returns
- Interim income statement and balance sheet
- Projected financials if you don’t have enough cash flow for the loan
- Management resume
- Business plan
- Entity or organization documents
- Personal financial statement
- Personal and business credit report
3. Get through underwriting
How stressful or blissful your underwriting process goes in either situation is up to the underwriter. You can have perfect credit and plenty of cash flow to make the payment, but an ornery underwriter can make the process worse, no matter what.
In each instance, the underwriter will calculate the loan payment based on the interest rate and the term of the loan and compare that to how much cash flow you bring in. Commercial underwriters will be less stingy than consumer underwriters and want you to have about 1.25 times as much cash flow as the required payments.
4. Order an appraisal
This is where commercial lenders are more stingy. You can get a mortgage with a 95% loan-to-value (LTV) pretty easily. That means you only have to bring 5% of the purchase price in cash. You can go even lower with some government programs.
The best you can do commercially is likely 90% with an SBA 504 loan. If you’re doing a conventional loan, banks will aim for a 75% LTV, and best case, you may be able to negotiate your way to 80% LTV if you have a big relationship at the bank.
Commercial and consumer lenders will order a real estate appraisal to obtain a valuation to use in their loan amount calculation. Both appraisal types are one of those things where you pay way more than you ever think you should to get a value for the lender to use to cover its tuchus in an audit. There is very little value for you, you just have to do it. Consumer appraisals are anywhere from $500 to $1,000 and commercial appraisals can cost anywhere from $2,500 to $10,000. Pretty soon, I’ll be writing about how to get a term loan to pay for the appraisal on your other term loan.
Once you’ve survived underwriting and are ready to close on the loan, you’ll sign all loan documents and have the title for the real estate transferred into your name at a title company. Commercial and consumer lenders require title insurance on real estate property, and title companies are experts at doing the little bureaucratic work to make sure the title is correctly assigned to you.
Consider your options
The next time you’re looking at a new office or thinking about buying a big piece of equipment, consider using leverage to make the purchase. As long as you budget well and can match revenue sources with your loan payment, you’ll be better off long term.