How do lenders decide the repayment term on a business loan?

You’re about to close on a business loan and your lender has sent you the final terms, interest rate, and fees before closing. Perhaps the interest rate, fees, or repayment term in the closing documents are different from what you were originally quoted.

If you work with a trustworthy lender, they’ll give you a clear explanation of why any details of your loan have changed before closing. One of the details that can change is the loan term, or the amount of time you have to pay back the loan.

The loan term affects whether you can afford to take on that debt, so it’s a big consideration for lenders when they evaluate the risk of lending to you, and for you when you evaluate whether the loan is a good deal.

The terms of a business loan vary from loan to loan, and they’re largely determined by the amount you want to borrow and how you want to use the funds. Here’s how lenders decide.

Understand Your Loan Term

The term of a business loan is the set amount of time in which you have to pay back the money you borrow. Some loan types, such as business lines of credit, have short terms, and they may require you to pay back the loan within twelve months. Some, like SBA 504 loans, are long-term loans that may give you up to twenty-five years to pay off.

Imagine if you were able to pay off a mortgage in 10 years instead of 30 years. You’d pay less interest on the loan and own your home sooner. But would your lender let you? They’d have to check that you could afford the higher monthly payments based on your income.

Lenders for business loans work the same way, evaluating whether you have enough income to cover the monthly payment. They might offer you a longer loan term, or they could determine that a shorter-term loan is best.

You’ll pay smaller payments with a longer-term loan and larger payments with a shorter-term loan. It’s OK to apply for a short-term loan if your cash flow can easily cover the payment amount. But if the monthly payment is close to, or larger than, your monthly cash flow, your financial situation could get dangerously tight.

That’s why it’s important to understand your loan term and be sure your cash flow can cover the payment before signing your loan documents at closing.

In many states, there’s a state Truth in Lending Act that requires your lender to provide you with an offer sheet outlining the loan term, interest rate, fees, and APR of your loan. It’s important to read this document closely, because you’ll want to refer to it both now and later.

Lenders Change Your Loan Term

Why would a lender change your loan term? In most cases, it’s to reduce the lender’s risk or to align the loan term with the reason for the loan or both. Here’s why that happens.

The first reason lenders change your loan term is when it doesn’t align with its use. Underwriters consider the useful life of equipment and may reduce your loan term to match that. For instance, if you asked for a ten-year term and you’re buying equipment that the lender believes will last for seven years, they may shorten your loan term.

That’s why it’s important to think about what you’ll be using your loan for before you talk to lenders and go into the process with a realistic expectation of the term.

Working capital needs like payroll, inventory, rent, and utilities generally have loan terms of about 3-6 years. And if you’re using the loan to purchase commercial real estate, it could be as long as 25 years.

The second reason why lenders may shorten your loan term is to lower their risk. In the lender’s eyes, the shorter the payback period, the more likely they think you’ll pay them back the full amount. Conversely, if you have a longer period of time to pay them back, that also means there’s a longer timeframe for something to go wrong in your business.

Lenders may use historical information about the average lifespan of businesses in your industry to inform their lending decision. For example, if businesses in your industry are typically open for seven years, lenders might not want to offer terms beyond that.

If your lender shortens your loan term, it doesn’t cost you anything to simply ask them why. A good lender will explain openly and honestly what their concerns are.

A Lender Offers You a Shorter Loan Term

Let’s say you’ve qualified for a loan with a ten-year payment term and budgeted accordingly, only to find out during the approval process your lender reduced the term to five years.

First, ask your lender why. In some cases, they may have misunderstood how you plan to use the loan. For example, they may have assumed you were purchasing office equipment when you’re actually purchasing equipment to be used in manufacturing. Once you clear up this misunderstanding, it could change the lender’s mind and give you the longer term you want.

If there wasn’t a misunderstanding, you’ll want to make sure your business can, in fact, afford the higher loan payment.

To illustrate, let’s look at a simplified example, excluding fees and other costs, of a $60,000 loan at an interest rate of 8%.

If the loan term is 10 years, your monthly payment would be about $728.

However, if your loan term was shortened to five years, your monthly payment would jump to about $1,217 - a much higher amount.

If you don’t ensure you can afford the larger payment before closing on your loan, your cash flow could suffer and make it hard for your business to pay its bills and payroll.

Next, it’s a good idea to take a look at your finances to see if the higher payment is feasible for your business. While your lender has likely reviewed this before changing the loan term, you and your financial team should look at your cash flow to see if it makes sense. If you can afford the higher payment, then you can move forward with the process.

But if you realize the payment is more than you can handle in your budget, there are still options you can pursue.

One option is to borrow less. Could you remove non-urgent items from your list and take a smaller loan? This could get your monthly payment back to what you’d initially planned.

Another option to consider is to improve your cash flow by reducing expenses or increasing profits. Either option makes your business stronger and helps you with financing.

Last but not least, it can be helpful to shop around with other lenders. You may find some that are willing to give you better loan terms. A more flexible lender might be willing to give you a longer-term loan.

For example, you could consider switching from an online lender to a community development financial institution (CDFI). CDFIs may be willing to give you a longer term and offer better APR. However, you’ll want to vet any lender’s reputation to ensure they’re trustworthy. If you come across a loan offer that seems too attractive, be suspicious. Working with predatory lenders can increase your risk of falling into deeper financial distress.