Term Loans as a Flexible Borrowing Instrument
A term loan is a type of debt that is paid back in regular installments. This means that it has a pre-agreed schedule of repayment over a period of 1 to 10 years. Most term loans come with a floating interest rate. Financial institutions extend financing to businesses and individual borrowers.
Characteristics of Term Loans
This is a type of short-term financing that allows businesses to purchase inventory, equipment, machinery, and other fixed, income-producing assets. Banks also extend funds to companies that need working capital for their daily operations. The funds can be used for investment or personal purposes, depending on the borrower. In addition, companies can use the money to acquire a business, for alterations, improvements, and refurbishments, and for the purchase of property equipment. Some institutions have a minimum loan amount, and repayment takes place in the form of monthly payments. With some banks, the duration of repayment is based on the amount of the monthly payment, meaning that it is not fixed. Borrowers make monthly payments that go toward the outstanding balance and the interest charges. While some loans come with a term of 10 years, borrowers pay more in interest charges when the term is longer.
There are different types of repayment schedules, depending on the financial institution. Generally, borrowers can choose from two options - even total or even principal payments. Under the first arrangement, they make increasing principal and decreasing interest payments. The amount of monthly payment remains the same during the term of the loan. When borrowers begin to pay more toward the principal, the outstanding balance decreases. This happens toward the end of the period, which means that the balance decreases at a slow, steady pace. Another option is to apply for a loan with even principal payments. In this case, borrowers pay the same amount toward the principal each month. For example, if you borrow $5,000 to be paid in 20 installments, each month you will be paying $250 toward the outstanding balance. The interest charges are calculated on the outstanding balance. Given that the principal decreases each month, borrowers also pay less in interest charges. Basically, this type of financing is characterized with an amortization of the outstanding balance and a fixed maturity.
Pros and Cons of Term Loans
Banks extend loans with flexible terms and conditions, and borrowers can choose from a fixed or adjustable interest rate. A fixed interest rate makes it easier for borrowers to predict payments and develop a budget. Term loans with an adjustable interest rate can help borrowers to save money. However, they are riskier because interest charges may increase with rate fluctuations. It should be noted that financial institutions often assess penalty fees for early prepayment. Thus, borrowers who prepay risk paying more in additional charges.
Generally, banks specify the period over which repayment takes place. Taking out a 10-year loan means that interest is paid during a 10 year period. Also known as commercial or traditional loan, this is a convenient way for new and established businesses to get access to funding. Generally, companies borrow to finance large purchases such as machinery, office equipment, and vehicles. It is usually start-ups that apply for financing, and the repayment schedule can be either monthly or quarterly. Some financial institutions require collateral, but borrowers benefit from lower interest rates.
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