Dangers of a Term Loan

There are many reasons that a business may choose to take out a term loan. Small businesses can use term loans to purchase needed equipment, purchase land and construct buildings, or simply use the proceeds from a term loan for working capital. In fact, term loans are one of the most popular types of financing options for small businesses. Term loans or fixed term business loans with a maturity of generally more than one year. However, there are also reasons that you might want to avoid taking out a term.

The Dangers or Disadvantages of Term Loans

When considering a business term loan, a business owner should understand that there are times when a term loan may not be the best type of financing for his or her business. Term loans are generally restrictive in the amounts available to be borrowed. For example, term loans are often used to purchase equipment; therefore, the amount will always be limited to the price of the equipment. Furthermore, if a term loan is used to acquire working capital for the business, banks will generally the limits the amount of capital that they are willing to loan.

Furthermore, pre-payments on business term loans may also be restricted. In fact, they are generally not allowed with most business term loans - unless you're willing to pay a fairly substantial penalty. Therefore, even if your business becomes very successful and you have a surplus of cash on hand, you may not be able to pay off the term loan without a substantial outlay of cash.

Furthermore, term loans usually will require a fairly substantial processing or application fee. In fact, with most term loans the processing fee will usually be a percentage of the total loan. Therefore, in addition to paying interest on the loan and being limited in the amount that is financed, you generally have to pay a fee for processing the loan.

Other Types of Roadblocks for Term Loans

In addition to the fairly restrictive terms for a business term loan, term loans usually require a very stringent approval process. Also, loans may be accelerated under many types of circumstances if strict conditions are violated. For example, term loan documents may restrict the type of cash dividends paid to owner shareholders and also restrict loans that may be taken out by owners or corporate officers.

Furthermore, term loan documents will generally require that the business be maintained in very good order and always maintain adequate insurance. In addition, many lenders will require the borrower to submit quarterly financial statements to the bank. If the bank is not pleased with the financial results of the business, many loan document contracts allow for the loan to be placed in default or be accelerated.

If the terms of the loan are accelerated, the bank may require that the loan balance be paid in full immediately. Finally, many banks will not make term loans without some sort of collateral; therefore, if a term loan is accelerated by the bank and the small business is not able to pay the loan off in full, the business risks losing the collateral to the bank to cover the balance of the loan.