Term Loans, Functions, Types, Example

Term Loan is a type of loan provided by financial institutions for a fixed amount and a pre-determined repayment schedule, typically ranging from 1 to 10 years or more. It is often used by businesses for capital expenditure, such as purchasing equipment, expanding operations, or constructing buildings. Individuals may also avail term loans for housing, education, or vehicle purchases. Term loans carry either a fixed or floating interest rate, and repayment is usually made in equal monthly installments (EMIs).

These loans are categorized based on duration: short-term (up to 1 year), medium-term (1–5 years), and long-term (above 5 years). The loan is generally secured with collateral, though some banks may offer unsecured term loans depending on the applicant’s creditworthiness. Term loans help in budgeting and planning as repayment terms are structured and predictable. They are an essential tool for both individuals and businesses to meet significant funding needs while ensuring systematic repayment over time.

Functions of Term Loan:

• Facilitates Capital Investment

Term loans enable businesses to fund capital expenditures such as purchasing machinery, upgrading infrastructure, or expanding facilities. Since these assets are essential for long-term operations, term loans provide the necessary financing with structured repayment over time. This allows companies to invest in growth without disturbing working capital, making it easier to manage large expenditures systematically. The loan tenure aligns with the useful life of the asset, ensuring efficient cost management and return on investment.

• Supports Business Expansion

Term loans provide the required funds to scale operations, open new branches, or enter new markets. Businesses use these loans to expand product lines, hire additional staff, or increase production capacity. The fixed repayment schedule allows for proper planning and avoids excessive strain on cash flows. This function plays a critical role in strategic growth, helping companies take advantage of market opportunities while spreading the cost of investment over several years.

• Enables Asset Acquisition

One major function of term loans is to finance the purchase of fixed assets, including land, buildings, vehicles, or plant equipment. Since these assets are expensive, businesses or individuals may not afford upfront payments. Term loans allow them to acquire necessary assets while repaying gradually over the asset’s lifespan. This function is crucial for startups, manufacturing firms, and service providers that require a strong asset base to operate efficiently and generate long-term income.

• Provides Predictable Repayment Structure

Term loans offer a fixed repayment plan, usually in the form of monthly EMIs, making financial planning easier for borrowers. This structured approach helps businesses and individuals manage their cash flows, allocate resources, and meet other financial obligations without disruption. Predictability in repayment also minimizes the risk of default, supports budgeting, and enables consistent financial performance tracking, especially in long-term financial strategies and planning.

• Improves Credit Profile

Successfully managing a term loan enhances a borrower’s creditworthiness. Regular and timely repayments reflect financial discipline, positively impacting credit scores. A strong credit profile makes it easier to secure larger or more favorable loans in the future. For businesses, this builds credibility with banks and investors, while for individuals, it strengthens personal finance history. Thus, term loans not only serve immediate funding needs but also help establish a solid credit track record.

• Offers Flexibility in Financing Options

Term loans are available in various forms—secured or unsecured, fixed or floating interest rates, and different tenures—making them adaptable to diverse borrower needs. Lenders may customize loan structures based on project size, repayment capacity, and business models. This flexibility allows borrowers to choose a loan that best aligns with their cash flow and growth strategy, making term loans a versatile financing solution for both corporate and personal financial goals.

Types of Term Loan:

• Short-Term Loan

Short-Term Loan is typically sanctioned for up to 1 year, mainly to meet immediate financial needs such as working capital, urgent equipment purchase, or managing cash flow gaps. These loans are often unsecured and come with higher interest rates due to the shorter repayment period and increased risk. Small businesses frequently use short-term loans to handle seasonal expenses or cover temporary fund shortages. Repayment may be structured as a lump sum or through monthly installments, depending on the lender’s terms.

• Medium-Term Loan

Medium-Term Loan usually ranges between 1 to 5 years and is often used by businesses for buying machinery, vehicles, or renovating infrastructure. These loans have moderate interest rates and require monthly or quarterly repayments. They may be secured by assets or guarantees. Medium-term loans help businesses invest in productive assets while balancing their debt obligations and earnings. Individuals also use them for funding home improvements, education, or large purchases. These loans offer flexibility and financial stability during business growth or life events.

• Long-Term Loan

Long-Term Loans extend beyond 5 years, often going up to 15 or 20 years. These loans are typically used for high-value investments like real estate, plant and machinery, or infrastructure projects. They require collateral and thorough credit evaluation. Interest rates may be fixed or floating, and repayment is done through monthly EMIs. Long-term loans allow borrowers to repay large sums gradually, reducing financial burden. They are crucial for long-term planning and expansion, supporting sustainable personal or business growth over time.

• Secured Term Loan

Secured Term Loan is backed by collateral such as property, equipment, or vehicles. The asset provides security to the lender in case of default. These loans generally have lower interest rates and higher loan amounts compared to unsecured ones. They are suitable for businesses and individuals needing substantial funds with better repayment terms. The collateral remains under the borrower’s use, but the lender holds a charge over it until the loan is repaid. Secured loans reduce credit risk for the lender.

• Unsecured Term Loan

An Unsecured Term Loan does not require any collateral and is granted based on the borrower’s credit history, income, and repayment capacity. These loans are common among salaried individuals and small businesses with strong financial records. Due to higher risk for the lender, interest rates are usually higher, and loan amounts are lower than secured loans. They are ideal for short-term needs like travel, medical expenses, or business emergencies. Approval is faster, but default consequences can include legal action and credit score damage.

• Fixed-Rate and Floating-Rate Loans

Term loans can have either fixed interest rates (constant over the loan term) or floating rates (varying based on market conditions). Fixed-rate loans offer predictable EMIs, making budgeting easier for borrowers, while floating-rate loans may start lower but change with benchmark rates like the repo rate. Businesses often prefer floating rates for long-term projects, anticipating rate drops. Individuals seeking stability in repayment opt for fixed-rate loans. The choice depends on market outlook, risk appetite, and financial goals.

Example of Term Loan:

• Business Term Loan

A manufacturing company requires ₹50 lakhs to purchase new machinery for expanding its production capacity. It approaches a bank and secures a 5-year term loan at an interest rate of 10% per annum. The loan is disbursed in full, and the company begins repaying the amount in monthly EMIs over the loan period. This term loan enables the business to scale up operations without exhausting working capital, while the fixed repayment schedule ensures better financial planning and budget control.

• Home Term Loan

An individual plans to buy a flat worth ₹40 lakhs but only has ₹10 lakhs in savings. They apply for a long-term home loan of ₹30 lakhs from a bank, repayable over 20 years at a fixed interest rate of 8%. The bank approves the term loan and disburses the amount directly to the property seller. The borrower starts monthly EMI payments, making homeownership affordable and manageable.

• Education Term Loan

A student secures admission to a reputed university abroad with a total fee of ₹25 lakhs. To finance the tuition and living expenses, she applies for an education term loan of ₹20 lakhs from a bank, repayable over 10 years after a moratorium period of 2 years. The bank disburses the amount in installments as per university requirements. After completing her studies, she begins repaying the loan in EMIs. This term loan supports higher education dreams without upfront financial pressure.

• Vehicle Term Loan

A self-employed professional wants to buy a commercial vehicle worth ₹15 lakhs for expanding his logistics business. He pays ₹3 lakhs as a down payment and takes a term loan of ₹12 lakhs from a bank, repayable over 5 years. The loan is secured against the vehicle. With fixed monthly EMIs, he manages his cash flows while generating income from the vehicle. This term loan helps him grow his business without depleting working capital.