Term loan duration small business lending

What Should the Duration of Your Term Loan be?

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If you’re ready to apply for a term loan for your small business, you want the terms of your loan to be as unique as your business. That said, one of the most important factors you should look at when taking on a term loan is…how long should your loan last? In the world of small businesses, the general impression has been that term loans offered by both banks and alternative lenders are typically short-term, usually with a maximum duration of 24 months. 

That has changed in recent years, however, as more banks and alternative lenders, such as Kapitus, have begun offering a new option to small business borrowers – term loans extending up to 60 months. In some cases, long-term loans may offer benefits for established small businesses such as a lower fixed payment. 

What Factors Should You Consider?

There are several factors to consider when determining what the duration of your loan should be. Additionally, the factors you should consider for a 60-month loan may be different than the ones you would consider for a loan that is 24 months or shorter. 

Josh Jones Kapitus small business lending

Josh Jones, Kapitus’ Chief Revenue Officer, said the duration of your term loan should be a major factor when deciding to get financing.

“If you’re able to get something approved outside of two years, you have a different decision as a business owner,” said Josh Jones, Kapitus’ Chief Revenue Officer. He added that when a small business owner is considering taking a loan of 24 months or shorter, they should examine what they are using the borrowed assets for and when they expect a return on those assets. 

For example, if your business is borrowing money to develop and market a new product that will be introduced to consumers in two years, then maybe a 24-month loan makes more sense for you. 

“For something 24 months or shorter, you have to look at your needs, and kind of do some liability matching to what the use of the capital is and whenever it is a return is going to happen,” said Jones.  

If you’re considering a 24-month loan, you should take into account the total amount that you would be paying back the lender over two years, and the fact that new debt will most likely be available to you, if needed, once you’ve paid off the loan. 

“Typically, debt payment coverage based on the use of the money is a big thing,” said Jones. “Or the fact that I know I have regular needs for capital. If I know my business can support that regular payment, I may not want anything longer than 24 months because I always want an available credit limit.”

Factors to Consider When Going Long

When considering taking a loan longer than 24 months, there are several factors that you need to consider the the total cost of the loan. If you apply for a term loan that will be paid back over 60 months, for example, the total interest will be higher on that loan because the lender is taking on longevity risk – the risk that your business may not still be around in five years. After all, the average lifespan of a small business in the US is 8½ years, according to NAV.

Are you, the borrower, willing to pay more for a five-year loan than a 24-month loan? The answer to this depends on your ability to consistently make payments, and what you are using the borrowed assets for. 

“With total cost, the shorter you go, the more the total cost goes down,” said Jones. “It is possible that the annual percentage rate (APR) of a 24-month loan will be more, but business owners should be more concerned about the total cost of financing, not just the APR. I’m borrowing this money, what is my total payback? If I can reduce the cost, if my business can support the payment, or my opportunity supports the payment of my debt, then that’s going to be the winning factor.”

With a longer-duration loan, you need to carefully consider:

  1. The amount you will be paying each month. Generally, the total cost of a 60-month loan will be greater than that of a 24-month loan (of the same amount). Therefore, if you need to borrow assets, and your cash flow only allows you to pay a limited amount of debt service coverage every month, a long-term loan may make more sense since the fixed payments will be lower than a short-term loan. 
  2. Prepay Options. If you take out a 60-month loan and you want to pay it back in full in 24 months, you may have a few options in terms of the total cost of capital. Some lenders will charge you a prepay penalty by charging you the interest you would have paid had the loan gone to term. Other lenders may give you a prepay discount – they’ll discount the amount of interest you would have owed had the loan gone to term. In either case, you should carefully examine which option would be cheaper for you when you set the terms of the loan. 

What Should I Use a 60-Month Loan For, and How Do I Qualify?

You can use the proceeds of a 60-month loan on anything you choose for your business, and the amount

term loan duration small business financing

Carefully consider the total cost of capital with a long-term vs. a short-term loan

taken out for a long-term loan is typically higher than a short-term one. 

Generally speaking, proceeds for a long-term loan are usually spent on permanent assets for your business, which could include the purchase of property, office equipment, office furniture, computers and company vehicles. Perhaps you need a long-term loan to acquire a well-established business to complement your own.

Be aware that the requirements and underwriting process for obtaining a loan beyond 24 months are more stringent than a standard two-year loan, mainly because the lender is taking on that longevity risk. 

“Even if you have a great credit score, it can be very difficult for a business to get a 60-month loan unless they have [many] years in business,” said Jones. “That’s because the likelihood of a business [that’s well established] making it another five years is much higher than a business that’s shorter. It’s not meant to be insulting to anyone’s good business, it’s just the way the stats play out.”

Talk to Your Financing Specialist

The duration of your term loan will depend on several different factors; but, like with most loans, your ability to pay the loan back will usually be the key. Examine your balance sheet and cash flow history, and talk to the financing specialist about whether lower payments over a longer time horizon may be a better option for your business.

Investing, small business, lending, small business owners, Kapitus

Should You Invest Your Business’ Surplus Cash? Absolutely

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If sales are booming and your small business is flush with cash, congratulations! While having a large surplus of cash is great for your small business, SMB owners also need to understand that the more surplus cash you have, the greater your chances are of losing money. 

How? Well, the rate of inflation reached a four-decade high of 7.9% in February, and the interest you’re collecting on your business savings account is almost certainly far less than that. Also, if you have any outstanding loans, the interest you’re paying on them is far greater than the interest from your savings account. You should also remember that we’re still going through “The Great Resignation,” so if you plan to increase your staff, current wage growth most likely is exceeding the interest that you’re getting from your business savings account.

How to Determine Timelines For Reinvesting Excess Cash

If you’re in the fortunate position of having a large cash surplus for your business, you have plenty of options to invest that cash in a way that you won’t lose money. Before you consider your options, however, you should first take the time to determine what you want to use that excess cash for. The first thing you want to do is assess what you want to spend it on, and what your time horizons may be for spending that cash. 

Kapitus, small business, investment, advisor, lending

A registered investment advisor can assist and educate you on your investment decisions.

You may want to seek advice from a financial advisor or a broker-dealer on how to invest your extra money. Take note that some financial advisors will only deal with you if you have a certain amount to invest and are generally more expensive than brokers, so choose carefully. If you feel you’re a sophisticated investor, you can always use online trading services such as Ameritrade, E*Trade or Robinhood. 

Short-Term Spending and Investing

If you have short-term plans to spend your surplus cash over the next year or less, such as expanding your business with additional staff; leasing a larger workspace; purchasing additional non-perishable inventory before inflation rises even further; or replacing old equipment crucial to your business in the next 12 months, there are investment instruments that can give you a much higher yield than your business savings account. 

You can also forgo investing by using your surplus cash to pay off any outstanding loans you may have, as many lenders do offer a pre-pay discount if you choose to pay off several types of loans before their terms expire.

If you are willing to go the investment route, there are plenty of asset management firms that offer a wide array of short-term investment options. As a business owner, you want these options to give you returns that are greater than your business savings account and are highly liquid. Some of these options include:

  • A money market account. This is an account that you can open at most large banks or by going through a broker and purchasing shares in a money market mutual funds. It will provide a higher yield than a savings account because it invests your money in short-term treasury bonds or commercial paper – a form of short-term financing typically used by large corporations. These types of accounts are considered very low risk and can be liquidated at a moment’s notice. 
  • A short-term treasury market mutual fund. Most investment managers do offer mutual funds designed for short-term investors. These funds tend to be low risk and typically invest in a mix of investment-grade and short-duration treasury bonds. Keep in mind, however, that mutual fund fees can be expensive, so shop around.
  • A certificate of deposit (CD). With the federal funds overnight rate set to rise, you may consider a CD. This is considered a low-risk account in which you can park your money and get a monthly fixed, compounding interest rate over a predetermined period that can be six months, a year or longer.  Most banks offer these types of vehicles, but you should shop around for ones that offer the best rate.
  • An exchange-traded fund (ETF).  ETFs are often cheaper than mutual funds because they don’t invest directly in securities like stocks and bonds, but rather, index futures. Put simply, they are funds that will typically generate the passive returns of whatever financial index you choose. Common indices include the S&P 500 Index (stocks) and the Bloomberg US Aggregate Bond Index (bonds). If your risk/return tolerance is high, you can invest in the stock market. Keep in mind that the average annual compounded return for the S&P 500 since its inception in the early 20th century is 10.5%, but the short-term volatility is high. 

How To Determine Your Business Short Term Spending vs. Long Term Investments

Are there long-term spending goals in your business plan, such as developing and offering a new product, or moving your headquarters to a larger space a few years down the road? The COVID-19 pandemic, which is now entering its third year, taught us that the economy can turn on a dime, so maybe you want to create an emergency cash reserve fund to keep your business afloat when the next recession hits. These are just a few examples of what you may have long-term spending plans for. 

If you have plans for your surplus cash that extend beyond a year, you can tolerate more risk, which means you have the potential to generate higher returns on your investments over the long haul. There are plenty of asset classes you can choose from that, despite having short-term volatility, have average annual returns that are much higher than anything you would see from a savings account or short-term bond investment. To put it simply, the longer your investment time horizon is, the greater your returns on capital can be. 

Your registered investment advisor (RIA) should educate you on the different asset classes and types of mutual funds that are best for long-term investing, as well as the basics such as risk management, modern portfolio theory, and portfolio optimization strategies. Depending on how much cash you have to invest, you may wish to invest in a basket of mutual funds for a diversified portfolio. Your RIA should also keep you informed on world events and how they may affect your portfolio.

Long-term Asset Classes

Some options you may consider for long-term investing include:

  1. An asset allocation mutual fund. If you want to invest in the long-term but don’t have the stomach for taking on excess investment risk, this may be the option for you. This type of mutual fund automatically allocates your assets among stocks, bonds and cash to optimize investment risk.
  2. Mutual funds that invest in equities (stocks). There are plenty of funds that invest in stocks. While these funds tend to be more expensive than low-risk bond funds – especially if they are actively managed – they tend to produce the highest returns over the long term. There are equity mutual funds that invest in everything from the S&P 500 Index to foreign stocks in emerging economies.
  3. Real Estate mutual funds. There are mutual funds that invest exclusively in various forms of real estate. Before you decide to invest, you should speak to your financial advisor and know that these types of mutual funds carry high management fees and high short-term volatility.
  4. Alternative investments. There are mutual funds that engage in exotic investment strategies, such as long/short, absolute return, and portable alpha strategies, and carry high management fees. These funds often seek to curb risk while delivering consistent returns. However, you need to make sure you get a solid understanding of these funds from your RIA before investing.

Don’t Lose Money!

Having surplus cash is a great thing for your small business, as it gives you many options for growing your business and surviving during a downturn. You must understand, however, that simply squirreling it away in your business savings account can cost you dearly. If you’re in such a fortunate position, speak with your accountant or an RIA to find out what your options are. 

 

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