Term Loan
What is a term loan?
A term loan is a loan from a bank or financial institution that is disbursed as a lump sum and repaid over a fixed period through scheduled instalments, typically equated monthly instalments (EMIs). It is used to fund specific long-term needs such as buying machinery, expanding premises, or acquiring another business.
Term loans are classified as short-term (repayable within one year), medium-term (one to five years), and long-term (over five years). They usually carry a defined tenure, interest rate, repayment schedule, and, for larger loans, specific security and covenants.
Why is a term loan important?
Term loans provide businesses with structured financing for large, long-term investments that cannot be funded from current cash flow alone. They allow businesses to acquire productive assets and expand capacity while spreading the cost over the useful life of the asset.
Term loans are also central to capital-structure planning. Combined with equity, they form the long-term capital base of a business. The tenure and repayment schedule are typically matched to the expected cash-flow generation from the underlying asset, so that repayments can be met without straining operations.
How does a term loan work?
1. Identifying the long-term need
The business identifies a specific long-term need, such as buying machinery, expanding premises, or acquiring another business, and estimates the funding required.
2. Applying to the lender
The business applies to a bank or financial institution with a business plan, financial statements, project details, projected cash flows, and any collateral required.
3. Getting the loan sanctioned and disbursed
The lender assesses the application, sanctions the loan amount, tenure, interest rate, and security, and disburses the funds either in a single tranche or in stages as the project progresses.
4. Repaying through scheduled instalments
The business repays the loan through scheduled instalments (typically monthly EMIs) over the agreed tenure, with each instalment covering both principal and interest.
5. Meeting covenants and reviews
The business meets any covenants agreed with the lender (such as maintaining minimum ratios or submitting periodic financials) and cooperates with periodic reviews of the loan performance.
Example
A logistics business in Nagpur decides to expand its fleet by buying 20 new trucks worth ₹6 crore. The business plans to fund ₹1 crore from internal accruals and the remaining ₹5 crore through a term loan.
It applies to a bank and secures a term loan of ₹5 crore for a tenure of seven years, secured by hypothecation of the new trucks and additional collateral. The bank disburses the loan in a single tranche after the business places orders with the truck manufacturer.
The business repays the loan through EMIs over the seven-year tenure. As the new trucks generate additional revenue from freight services, the additional cash flow covers the EMI payments comfortably. The loan is fully repaid at the end of the tenure, and the trucks continue to serve the business unencumbered.
Key points to remember
- A term loan is disbursed as a lump sum and repaid over a fixed period through scheduled instalments (typically EMIs).
- Term loans are classified as short-term (up to one year), medium-term (one to five years), and long-term (over five years).
- They are used to fund long-term investments such as machinery, premises, and acquisitions.
- The tenure and repayment schedule are typically matched to the cash-flow generation from the underlying asset.
- Larger term loans usually require security (hypothecation of assets, collateral) and specific covenants.
- Interest rates depend on the borrower's credit profile, tenure, security, and the lender's benchmark rate.
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A term loan funds long-term needs (machinery, premises, acquisitions) and is repaid through EMIs over a fixed tenure. A working capital loan funds day-to-day operations and is typically short-term or revolving. Both serve different purposes and may be used together.
Term loans are classified by tenure into short-term (up to one year), medium-term (one to five years), and long-term (over five years). By purpose, they include machinery loans, business expansion loans, commercial vehicle loans, and acquisition financing.
Larger term loans typically require security, such as hypothecation of the asset funded, along with additional collateral. Smaller or short-term unsecured term loans are available from banks, NBFCs, and fintechs, usually at higher interest rates.
The EMI is calculated based on the loan amount, interest rate, and tenure, using standard amortisation formulas. Each EMI covers a portion of principal and a portion of interest, with the interest component higher in early instalments and the principal component higher in later instalments.
Missed or delayed EMIs attract penal interest, late fees, and damage to the borrower's credit standing. Persistent default can lead to classification as a non-performing asset, invocation of security, and legal action by the lender under laws such as the SARFAESI Act.
