What Are the Terms of a Business Loan?

Business loans provide capital for various needs, from covering operational expenses to funding expansion projects. Understanding the terms of these loans is important for business owners to manage their finances effectively and avoid potential pitfalls. Each loan agreement contains specific conditions that define the borrowing arrangement, impacting both immediate financial obligations and the long-term health of a business. A thorough review of these terms helps ensure that a loan aligns with a business’s financial capacity and strategic goals.

Understanding Core Financial Terms

The principal amount is the original sum of money borrowed. As payments are made, the outstanding principal balance decreases. For example, if a business borrows $100,000, that initial $100,000 is the principal.

Interest rates determine the cost of borrowing. Lenders offer fixed or variable rates. A fixed interest rate remains constant throughout the loan term, providing predictable monthly payments. Conversely, a variable interest rate can fluctuate based on market conditions, introducing uncertainty as payments can increase or decrease over time.

Interest is generally a percentage of the outstanding principal balance. As payments are made, a portion goes toward interest, and another portion reduces the principal. The loan term specifies the period over which the loan must be repaid, typically ranging from months to several years.

The repayment schedule outlines how and when payments are structured. Each payment usually comprises both principal and interest. Early in the loan term, a larger portion goes towards interest, with more shifting to principal reduction as the loan matures. This process, known as amortization, systematically pays down the loan principal through regular, scheduled payments.

Additional Costs and Charges

Beyond principal and interest, business loans often come with additional costs. Origination fees are upfront charges assessed by the lender for processing a new loan. These fees cover administrative costs of underwriting and disbursing the loan.

Closing costs encompass expenses incurred when the loan agreement is finalized. These can include legal, appraisal, and underwriting fees, and are usually due at closing.

Prepayment penalties are fees charged by some lenders if a borrower repays a loan ahead of schedule. These penalties can be a percentage of the remaining balance or a flat fee, varying by loan type and lender.

Late payment fees are imposed when a scheduled loan payment is missed. Administrative or servicing fees may also be charged, covering costs associated with processing payments and account management.

Security Requirements

Lenders often require security for business loans to mitigate risk. Collateral is a common form of security; if the borrower fails to repay, the lender can seize and sell it to recover the debt.

Common examples of collateral include:
Real estate, such as land or buildings.
Equipment, such as machinery or vehicles.
Inventory, like raw materials or finished goods.
Accounts receivable, representing outstanding invoices from customers.

A lien is a legal claim against a borrower’s property or assets. While a lien grants the lender a claim, assets do not change hands as long as repayment obligations are met. Lenders often file a Uniform Commercial Code (UCC) lien, which publicly establishes their claim on specified business assets.

Personal guarantees obligate the business owner to personally repay the business debt if the business cannot, putting personal assets at risk if the business defaults. This ties the owner’s personal credit and assets to the business loan.

Operational and Financial Agreements

Loan agreements often include operational and financial agreements, known as covenants. These covenants protect the lender’s interests and ensure the borrower maintains a stable financial position.

Affirmative covenants detail actions the borrower must take. Examples include maintaining adequate insurance coverage on business assets, providing regular financial statements to the lender, and maintaining proper business records. These stipulations help the lender monitor the business’s health.

Negative covenants specify actions the borrower must not undertake without lender consent. These restrictions prevent activities that could jeopardize the business’s financial stability. Common examples include prohibitions on taking on additional debt, selling substantial business assets, or paying excessive dividends.

Financial covenants are specific metrics or ratios the borrower must maintain. These measures provide the lender with assurance of the business’s financial health. Examples include maintaining a certain debt-to-equity ratio, which limits debt relative to equity, or a minimum debt service coverage ratio, which ensures sufficient cash flow to cover debt payments. Breaching these benchmarks can trigger a default event.

Consequences of Non-Compliance

A default occurs when a borrower misses payments or breaches other covenants. While a single missed payment typically results in delinquency, multiple missed payments or a significant breach of a covenant can trigger a formal default.

Upon default, lenders have several remedies. One immediate action is to accelerate the loan, demanding the entire outstanding balance be repaid immediately. This means the full amount, including remaining principal, accrued interest, and any penalties, becomes due at once.

If the loan was secured by collateral, the lender can seize and sell those assets to satisfy the debt, potentially leading to the loss of valuable business assets. If a personal guarantee was signed, the lender can pursue the business owner’s personal assets, such as bank accounts or wages, to cover any remaining debt.

Non-compliance also negatively impacts both the business’s and the owner’s credit scores. Late payments, collections, and judgments are reported to credit bureaus, making it difficult to secure future financing and potentially leading to higher interest rates. This damaged credit standing can persist for several years, affecting the business’s ability to operate and grow.