Understanding Fixed-Rate and Term Loans
Term loans are typically provided to businesses by banks and credit unions. They provide borrowers with consistent capital and repayment terms Given that the lender is committing to the rate and repayment schedule for several years, the interest rate is frequently higher than a similarly secured line of credit. Term loans can work very well for borrowers when financing assets with longer useful life expectancy. For example:
Your business has recently entered into a long-term relationship with a major customer to purchase $1,000,000 of product from you per year for 10 years. In order to produce this product, your business needs to increase capacity by adding another machine at a cost of $3,000,000. After reviewing your options, you determine it is best to purchase the equipment with a fully amortizing term-loan maturing in 5 years at 5% interest and monthly payments of $56,613. Given that you expected monthly revenue is $83,333 ($1,000,000/12) you are comfortable with this repayment schedule. You may otherwise elect to amortize the loan over 10 years with a 5 year fixed interest rate and maturity. This would reduce your monthly payment to $31,819, but leave you with an outstanding balance of $1,381,703 in 5 years when the loan must be repaid or refinanced.
The fully-amortizing loan reduces your exposure to interest rate changes, but leaves you with a much higher monthly obligation. The partially amortization loan provides you with greater operating/cash-flow flexibility over the early years of the loan, but exposes you to significant risk in 5 years.
Important Terms
Loan Amortization – The period of time over which the payments for the loan are calculated. This is the amount of time it will take to pay-off the loan for a given payment. For Example:
A $100,000 loan at 5% Amortized over 10 years would be fully repaid after 120 monthly payments of $1,066.66. If this loan were Amortized over 5 years, it would be fully repaid after making $1,887.12.
Fixed Rate Period – Most residential/home mortgages are fully amortizing loans with fixed rates for the duration of the mortgage (ex. 30 year and 15 year mortgages). However, many commercial (and some residential) loans are only fixed for a few years and do not fully amortize (i.e. are not fully repaid when the loan comes due or interest rate changes). For example:
Your $100,000 loan has a fixed rate of 5% for 5 years and is amortized over 10 years. After 5 years of making 60 monthly payments of $1,066.66 (calculated above), your loan will still have a balance due of $56,205. At this time you must either pay the remaining balance of $56,205 or refinance the remaining balance at the current interest rate.
