Term loan

A term loan is credit advanced as a lump sum and repaid over a fixed period according to an agreed schedule. The amount, tenor, interest rate and repayment dates are set at the outset, and the facility does not replenish as it is repaid — once repaid, the loan is closed.

That last point is what separates a term loan from every other major credit product. A term loan amortises toward zero on a known path. Revolving facilities do not.

Key characteristics

• Disbursement: A single lump sum, or staged drawdowns against milestones
• Tenor: Fixed and agreed in advance, from months to decades
• Repayment: Scheduled instalments on set dates
• Availability: Does not replenish; repaid principal cannot be redrawn
• Interest: Fixed or variable, charged on the outstanding balance
• Security: Secured or unsecured depending on size, tenor and borrower
• Covenants: Common on commercial facilities, rare on small consumer loans
• Purpose: Usually tied to a defined use, especially asset acquisition

Term loan vs. revolving credit

The distinction governs which product suits which need, and getting it wrong is a common and expensive error.

• Term loan: Lump sum with scheduled repayment to zero; does not replenish. Best suited to a defined one-off need with a known cost.
• Revolving credit facility: Agreed limit drawn and repaid repeatedly; replenishes. Best suited to recurring, variable funding needs.
• Overdraft: Account permitted to run negative to a limit; replenishes. Best suited to short-term timing gaps in day-to-day cash flow.
• Line of credit: Pre-approved limit drawn as required; replenishes. Best suited to uncertain timing or amount.
• Bridge loan: Lump sum repaid from a defined future event; does not replenish. Best suited to bridging a gap before a sale, refinance or receipt.

The practical rule: use a term loan to buy something, and a revolving facility to fund a cycle. Financing a vehicle on an overdraft leaves the borrower with a permanent hard-core balance that no schedule ever clears. Financing seasonal stock purchases on a term loan leaves them repaying rigid instalments through months when the cash cycle has not yet turned.

Anatomy of a term loan

• Principal — the amount advanced.
• Tenor — the total period from drawdown to final repayment.
• Drawdown — release of funds, either in full or in tranches against conditions precedent.
• Grace period — an initial interval with no repayment, or with interest only, allowing the financed asset to begin generating returns.
• Interest rate — fixed for the term, or variable against a reference rate.
• Repayment frequency — monthly, quarterly, or matched to the borrower's cash cycle.
• Amortisation schedule — the table showing each instalment split between interest and principal, and the balance remaining.
• Fees — arrangement, commitment, legal, valuation, and sometimes prepayment.
• Covenants — undertakings the borrower must observe throughout the term.
• Events of default — the circumstances allowing the lender to demand immediate repayment.

Amortisation structures

Fully amortising. Equal instalments across the term, with the balance reaching zero at maturity. Early instalments are mostly interest, later ones mostly principal, because interest accrues on a declining balance. Borrowers frequently misread this as a trick; it is simply the arithmetic of charging interest on what is still owed.

Balloon. Regular instalments smaller than full amortisation requires, leaving a large final payment. Lowers monthly cost and creates refinancing risk at maturity — the borrower must have the balloon sum or a facility to replace it.

Bullet. No principal repayment during the term. Interest is serviced periodically and the entire principal falls due at maturity. Common in corporate finance and in lending against an expected liquidity event.

Interest-only period. Principal repayment deferred for a defined initial phase, then full amortisation across the remainder. Instalments step up sharply at the transition, which is the point most borrowers underestimate.

Step-up or step-down. Instalments that rise or fall on a set path, matched to expected income growth or to a declining subsidy.

Irregular or seasonal. Instalments weighted to the months when income actually arrives. Standard practice in agricultural lending and underused elsewhere.

Classification by tenor

• Short-term — up to about one year. Working capital, small equipment, bridging a specific need.
• Intermediate or medium-term — roughly one to five years. Vehicles, machinery, business expansion, refurbishment.
• Long-term — beyond five years, sometimes to twenty-five or thirty. Property, major plant, infrastructure.

The general principle is tenor matching: the repayment period should approximate the useful life of what is financed. Funding a ten-year asset over two years starves the borrower's cash flow; funding a two-year asset over ten leaves them paying for something they no longer own.

Pricing

Fixed rate. The rate is set for the term. The borrower gains certainty and gives up any benefit from falling rates. Fixed-rate facilities usually carry heavier prepayment terms, because the lender has hedged or funded to the expected maturity.

Variable rate. Priced as a reference rate plus a margin, and resetting when the reference moves. The borrower carries the rate risk, which is why variable-rate lending should be stress-tested at a materially higher rate than the one offered.

Flat rate vs. reducing balance

This distinction is the single largest source of pricing confusion in lending, and it materially changes what a loan costs.

Reducing balance. Interest is charged on the outstanding principal, which falls with each repayment. Total interest is proportionately less as the loan runs down.

Flat rate. Interest is calculated on the original principal for the whole term, regardless of repayments made. A borrower who has repaid most of the principal is still charged interest as though nothing had been repaid.

A flat rate is roughly equivalent to a reducing-balance rate close to double its stated level over a fully amortising term. A loan quoted at a flat rate that looks cheaper than a reducing-balance alternative is usually considerably more expensive. Comparing the total cost of credit — every payment made over the life of the loan — is the only reliable way to compare offers quoted on different bases, and many jurisdictions now require disclosure of an effective annual rate for exactly this reason.

Security and covenants

Term loans may be secured against property, equipment, receivables, financial assets or personal guarantees, or advanced unsecured where the borrower's standing supports it.

Financial covenants on commercial facilities commonly include:

• Debt service coverage ratio — a minimum ratio of operating income to total debt service
• Gearing or debt-to-equity — a ceiling on leverage
• Interest cover — a minimum ratio of earnings to interest cost
• Current ratio — a minimum liquidity position

Affirmative covenants require the borrower to do things: supply audited accounts within a set period, maintain insurance, pay taxes, maintain the security, permit inspection.

Negative covenants prohibit things: taking on further debt beyond a threshold, granting security to another lender, disposing of major assets, changing the business, or distributing profits while in breach.

Events of default typically include missed payment, covenant breach, insolvency, material adverse change, cross-default on other facilities, and misrepresentation. Breach usually triggers a cure period first; where it is not cured, the lender may accelerate — declaring the entire balance immediately due — and enforce security.

Covenant breach is often a warning signal rather than a loss event. A borrower whose interest cover slips below threshold is frequently still solvent, and the covenant's real function is to give the lender a seat at the table before the position deteriorates further.

Term Loan A and Term Loan B

In syndicated corporate lending, two tranches are commonly distinguished:

Term Loan A — amortising over the term, shorter tenor, typically held by banks, priced lower.

Term Loan B — minimal amortisation with a large bullet at maturity, longer tenor, typically held by institutional investors such as credit funds, priced higher to compensate for the back-loaded repayment.

The terminology is standard in leveraged finance and rarely appears in small business or consumer lending.

Prepayment and early settlement

Prepayment penalties compensate the lender for interest it expected to earn and for the cost of unwinding its own funding. They are common on fixed-rate and long-tenor facilities, and are increasingly restricted or capped by consumer credit regulation.

Early settlement calculation matters more than borrowers realise. On a reducing-balance loan, settling early saves the interest that would have accrued on the remaining balance. Under a flat-rate structure, or where a lender applies a front-loaded interest allocation method such as the Rule of 78, the saving from early settlement is substantially smaller than the borrower expects — the interest has already been allocated to the earlier periods. Any settlement quotation should be requested in writing and checked against the outstanding principal.

Risks

For borrowers:

• Rigid schedule. Instalments fall due whether or not income arrived that month.
• Balloon and refinancing risk. A large final payment assumes the borrower can raise or refinance it at maturity.
• Rate risk on variable facilities, particularly over long tenors.
• Covenant breach triggering acceleration on a loan the borrower was otherwise servicing.
• Tenor mismatch, repaying long after the financed asset stopped producing.

For lenders:

• Duration risk. A long fixed-rate loan funded by short-term deposits exposes the lender to rate movement.
• Slow deterioration. A term loan performs until it does not; without covenants and monitoring, the first signal may be a missed payment.
• Concentration by sector, tenor or single borrower across a term book.
• Prepayment risk, where borrowers refinance away as rates fall.

Frequently asked questions

How is a term loan different from a mortgage? A mortgage is a long-tenor term loan secured specifically on real property. All mortgages are term loans; most term loans are not mortgages.