A term loan is a fixed sum of money a borrower receives in a single disbursement and repays on a set schedule of principal and interest over a defined period. Businesses use term loans to finance specific, planned purchases like equipment, real estate, or acquisitions, where the cost is known upfront and the repayment can be mapped years in advance. The loan agreement sets the note amount, the interest rate, and the maturity date at closing, so both sides know exactly what the obligation looks like for the life of the loan.1U.S. Securities and Exchange Commission. Commercial Loan Agreement (RF Monolithics, Inc.)
The defining mechanic is simple. The lender transfers the full principal at closing, and the balance only goes in one direction after that: down. Each scheduled payment chips away at what’s owed until the loan is retired. There is no redrawing, no revolving availability, no fluctuating balance.
How a Term Loan Differs From a Line of Credit
The most common point of confusion is the line between a term loan and revolving credit. A business line of credit lets you borrow against an available balance, pay it down, and borrow again, with interest charged only on what you’ve drawn at any given time. That structure fits payroll gaps, seasonal inventory, and other short-term cash needs where the amount required varies week to week.
A term loan is designed for a one-time capital need. You receive the money, deploy it, and spend the next several years paying it off. The principal declines with every payment and never goes back up. That predictability is the main appeal. When a company borrows $2 million for a piece of equipment, the finance team can budget every future payment with certainty. For long-lived assets with payoff horizons of five, ten, or twenty years, that planning clarity matters.
Not every term loan arrives all at once. A delayed draw term loan lets the borrower withdraw amounts at scheduled intervals from a pre-approved total, often tied to construction milestones or earnings targets. Once the draw period closes, the loan behaves like any other term loan: the balance amortizes down on a fixed schedule.
Short, Intermediate, and Long-Term Loans
Term loans are grouped by maturity, and the right maturity usually tracks the useful life of whatever is being financed. Matching the repayment timeline to the asset’s productive life keeps cash flow aligned with the value the purchase is generating.
Short-Term Loans
Short-term loans run roughly one to three years. They fit specific, temporary needs: a large inventory order for a single contract, bridging cash flow while waiting on a receivable, or a project that pays for itself quickly. The compressed window pushes monthly payments higher relative to the loan amount, but total interest paid over the life of the loan is lower.
Intermediate-Term Loans
Intermediate-term loans run roughly three to seven years. This is the typical range for equipment financing, vehicle fleets, and technology upgrades, where the asset will be productive for several years but not decades. The schedule lines up with the depreciation period for most commercial equipment, so the asset keeps generating revenue throughout the time you’re paying for it.
Long-Term Loans
Long-term loans extend from seven years up to twenty-five years or more, with commercial real estate loans sometimes stretching further. These are reserved for major capital expenditures like building construction, facility expansion, or property acquisition. The extended maturity keeps periodic payments manageable on very large balances. The trade-off is substantially more total interest paid over the life of the loan compared to a shorter term.
Fixed and Floating Interest Rates
Every term loan charges interest in one of two ways. A fixed-rate loan locks in a single interest rate from day one through final payment. Debt service never changes, regardless of what happens in the broader economy. For businesses operating on thin margins or financing assets over long horizons, that certainty can be worth paying a slightly higher starting rate.
A floating-rate loan ties the interest rate to a market benchmark that resets periodically. Since mid-2023, the dominant benchmark for U.S. dollar lending has been the Secured Overnight Financing Rate, or SOFR, which replaced LIBOR after that older benchmark was phased out.2Federal Reserve Bank of New York. Transition from LIBOR The loan rate is calculated as the benchmark plus a fixed spread, sometimes called the credit margin, which reflects the borrower’s creditworthiness. If a loan is priced at SOFR plus 2.5%, and SOFR sits at 4.3%, the borrower pays 6.8%. When the benchmark moves, the rate moves with it. Floating rates usually start lower than comparable fixed rates, but they expose the borrower to rising costs if interest rates climb.
How Repayment Is Structured
How the principal gets paid back varies by loan structure. The repayment method affects both the size of regular payments and how much is owed at the end of the loan term.
Standard Amortization
Most term loans use an amortizing structure. Each payment covers a portion of the principal plus accrued interest. In the early years, the bulk of each payment goes toward interest because the outstanding balance is still large. As the balance shrinks, the interest portion drops and more of each payment goes to principal. By the final payment, the loan is fully retired. Commercial term loans are typically amortized monthly or quarterly.
Balloon Payments
Some term loans, particularly in commercial real estate, use a balloon structure. Periodic payments are calculated as if the loan will amortize over a long period, say 25 years, but the full remaining balance comes due at a much earlier maturity date, say 7 or 10 years. The result is lower monthly payments throughout the term, followed by a large lump-sum payment at the end. Borrowers using this structure generally plan to refinance or sell the underlying asset before the balloon comes due. The risk is that if refinancing isn’t available when the balloon matures, the borrower is facing a massive payment with limited options.
Prepayment Penalties
Paying off a term loan early sounds like a win, but many commercial loans include prepayment penalties that compensate the lender for lost interest income. These penalties take several forms:
- Percentage of balance. A flat percentage of the remaining balance, often on a sliding scale. A common structure starts at 5% in year one and steps down by 1% annually until it reaches zero.
- Yield maintenance. A lump sum designed to make the lender whole for the difference between the loan’s interest rate and the current market rate. This penalty can be substantial when interest rates have fallen since the loan was originated.
- Defeasance. Common in securitized commercial real estate loans, defeasance requires the borrower to purchase government bonds that replicate the remaining payment stream. The bonds replace the property as collateral, releasing the lien. The mechanics are complex and typically require hiring a specialized firm.
- Lockout periods. Some loans prohibit any prepayment for a set number of years. Once the lockout expires, a declining penalty schedule usually kicks in.
SBA 7(a) loans have their own prepayment rules. If the loan term exceeds 15 years and the borrower voluntarily repays 25% or more of the outstanding balance within the first three years, the fee is 5% in the first year, 3% in the second, and 1% in the third.3U.S. Small Business Administration. 7(a) Loans
Cash Flow Sweeps
Leveraged term loans often include excess cash flow sweep provisions. These require the borrower to apply a percentage of surplus cash flow each year toward accelerated principal repayment. The sweep percentage is negotiable but commonly falls between 50% and 75% of excess cash flow. Many agreements include step-downs where the percentage decreases as the borrower’s leverage ratio improves. Cash flow sweeps give lenders extra protection on riskier credits, but they can constrain a growing company’s ability to reinvest profits.
Collateral, Guarantees, and Personal Exposure
Lenders manage their risk by controlling what happens if the borrower stops paying. Protection comes in layers: collateral, personal guarantees, and the loan’s underlying credit structure.
Secured Loans
A secured term loan requires the borrower to pledge specific assets as collateral. Equipment, inventory, real estate, and receivables are all commonly pledged. On default, the lender has the legal right to take possession of the collateral and sell it to recover what’s owed. Under Article 9 of the Uniform Commercial Code, the lender can sell collateral through public or private sales, but every aspect of that sale must be commercially reasonable.4Legal Information Institute. UCC 9-610 Disposition of Collateral After Default Because the lender has this fallback, secured loans carry lower interest rates and more favorable terms than unsecured alternatives.
Unsecured Loans
An unsecured term loan relies entirely on the borrower’s creditworthiness, cash flow history, and financial strength. No specific asset backs the debt. If the borrower defaults, the lender’s recourse is limited to suing for repayment through the courts rather than seizing identified property. This higher risk profile means unsecured loans are generally reserved for well-established companies with strong balance sheets and proven track records. Expect higher interest rates and stricter covenants compared to secured financing for the same amount.
Personal Guarantees
For small and mid-sized businesses, lenders frequently require the business owner to personally guarantee the loan. A personal guarantee means the owner is on the hook individually if the business can’t pay. The scope of that exposure depends on the type of guarantee.
Under an unlimited guarantee, the lender can pursue any of the guarantor’s personal assets, including savings, retirement accounts, and their home, to recover the full loan amount plus interest and legal costs. There is no cap on personal liability. Under a limited guarantee, personal exposure is capped at a set dollar amount or percentage of the loan. When multiple owners are involved, each may guarantee only their proportional share.
The distinction between “several” and “joint and several” liability matters when partners are involved. Under a several guarantee, each partner is responsible only for their predetermined share. Under a joint and several guarantee, the lender can pursue any single partner for the entire outstanding balance, regardless of ownership percentage. If one partner disappears or goes bankrupt, the others could end up responsible for the whole loan.
Loan Covenants
Covenants are the rules written into the loan agreement to keep the borrower’s financial condition healthy enough to service the debt. Violating a covenant, even without missing a single payment, constitutes a technical default that gives the lender the right to accelerate the loan and demand full repayment immediately.5Federal Reserve Bank of Chicago. What Are the Consequences of a Covenant Violation on Subsequent Loans to the Borrower In practice, lenders usually negotiate a cure period or waiver rather than pulling the trigger, but the leverage shifts dramatically once the borrower is in breach.
Financial Covenants
Financial covenants set quantitative benchmarks tied to the borrower’s financial statements. The most common require a minimum debt service coverage ratio (ensuring operating income can cover loan payments with room to spare) or a maximum leverage ratio (total debt relative to earnings). A typical covenant might cap the debt-to-equity ratio at 2.0 or require a debt service coverage ratio of at least 1.25. These ratios are tested quarterly or annually, and the loan agreement specifies exactly how each figure is calculated.
Affirmative and Negative Covenants
Affirmative covenants are things the borrower must do: deliver audited financial statements within a set number of days after fiscal year-end, maintain insurance on pledged assets, stay current on taxes. These are largely administrative, and compliance is straightforward for a reasonably organized business.
Negative covenants restrict what the borrower can’t do without the lender’s consent. Common restrictions include selling major assets, taking on additional debt beyond a specified threshold, paying dividends above a certain level, or changing the fundamental nature of the business. These provisions prevent the borrower from hollowing out the company or piling on risk while the lender’s money is still outstanding.
Fees Beyond the Interest Rate
The interest rate isn’t the only cost of a term loan. Upfront and ongoing fees add to the total expense and are worth factoring into any comparison between offers.
- Origination fee. A one-time charge at closing, typically 0.5% to 1% of the loan amount on conventional commercial loans. SBA loans may carry higher origination and guarantee fees.
- Legal and documentation fees. The borrower often covers the lender’s legal costs for drafting and reviewing the loan agreement, which can run several thousand dollars on larger transactions.
- Appraisal and inspection fees. For loans secured by real estate or specialized equipment, the lender will require an independent valuation. Commercial real estate appraisals alone can cost several thousand dollars depending on property complexity.
- Filing fees. When the lender takes a security interest in personal property, they file a UCC-1 financing statement with the state. These fees are modest, but loans secured by real estate also require mortgage recording with the county, which adds per-page filing charges that vary by jurisdiction.
Some lenders also charge annual administrative fees or unused commitment fees on delayed draw facilities. Ask for a complete fee schedule before signing to compare the all-in cost, not just the interest rate.
Tax Treatment of Interest
Interest paid on a business term loan is generally deductible as a business expense. The tax code effectively subsidizes borrowing cost by allowing the deduction of interest payments from taxable income.6Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest The loan principal itself is not income when received and not deductible when repaid. Only the interest portion of each payment generates a tax deduction.
The deduction isn’t unlimited for larger businesses. Section 163(j) of the Internal Revenue Code caps the business interest deduction at the sum of business interest income plus 30% of adjusted taxable income for the year. Any interest that exceeds the cap carries forward to future tax years.7Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
Two nuances apply. Small businesses that meet the gross receipts test under Section 448(c), an inflation-adjusted revenue threshold, are exempt from this cap entirely. And legislation enacted in 2025 restored the ability to add back depreciation and amortization when calculating adjusted taxable income for tax years beginning after December 31, 2024. This change makes the 163(j) limitation less restrictive for capital-intensive businesses that carry significant depreciation charges.8Internal Revenue Service. IRS Updates Frequently Asked Questions on Changes to the Limitation on the Deduction for Business Interest Expense
What Default Looks Like
Default doesn’t always mean a missed payment. Tripping a financial covenant is technically a default even if every payment arrived on time. But the consequences of a payment default are more immediate.
Most loan agreements include an acceleration clause that allows the lender to declare the entire remaining balance due immediately on default. In practice, lenders don’t always exercise this right on the first missed payment. There’s usually a cure period, often 10 to 30 days, during which the borrower can bring the loan current without triggering acceleration. The cure period and its terms are spelled out in the loan agreement, and negotiating a reasonable one during the initial deal is worth the effort.
If the loan is secured and the default isn’t cured, the lender can take possession of the collateral through legal proceedings or, in many cases, through self-help repossession as long as it doesn’t involve a breach of the peace. After taking possession, the lender sells the collateral and applies the proceeds to the outstanding debt.4Legal Information Institute. UCC 9-610 Disposition of Collateral After Default If the sale doesn’t cover the full balance, the borrower still owes the difference, called a deficiency. If the business owner signed a personal guarantee, the lender can pursue that deficiency against personal assets.
A default also triggers cross-default provisions in other loan agreements. If a company has multiple loans, defaulting on one can put all of them in technical default simultaneously. This cascading effect is how a manageable problem turns into a crisis, and it’s one reason experienced borrowers pay close attention to covenant compliance well before they’re in danger of a breach.