Corporate Finance
Feb 20, 2023
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This guide explains how term loans are structured and explains how amortization works. This guide is designed to accompany our guide: Term Loans (Part 1): How They Work. That guide explains what term loans are and how they work, this guide goes into depth about how these loans are actually structured and amortized as well as what these terms mean. Some key takeaways about term loan structure and amortization:
A term loan is an arrangement where a lender gives a business an upfront lump sum of cash for a specific purpose in exchange for the agreed-upon repayment terms of the loan.
Usually, businesses use term loans to finance the purchase of specific assets. Examples of assets term loans are frequently used to purchase include equipment and commercial real estate.
Term loans are for a fixed amount, for a fixed term, and they are associated with a specific purchase or financing endeavor.
Term loans are provided by commercial banks, insurance companies, and credit companies. These companies specialize in these sorts of loans, among other things. Businesses apply for term loans directly with the lender.
Expanding on the basics, next we’ll cover how term loans are structured.
To understand how term loans are structured, you first need to understand the basic concepts of loans. For more information on this, we recommend our guide: Term Loans (Part 1): How They Work.
Loans consist of several components: the principal, interest, and the term length.
Principal is the face value of the credit the lender is extending to the borrower—it’s the amount of money they are borrowing. The principal will need to be repaid to the lender by the business (borrower) at some point in the future, as per the agreement.
Interest is the additional charge on top of the principal that’s paid as compensation to the lender in exchange for the risk they take in providing the loan to the business. Here’s an easy way to understand interest from both perspectives: interest is the cost of borrowing the money for the business (borrower), and it’s the compensation that the lender gets in return for loaning the borrower the money.
The term length is the period from when the lender provides the business (borrower) with the cash up until the business has repaid the loan and any interest required, as per the agreement.
Now that we understand that term loans involve principal, interest, and a term length, we’ll look at how these concepts come together.
Building on the concepts of principal, interest, and term length; we can look at amortization.
Amortization is a concept in lending that refers to paying off debt in installments of principal and interest, over time, through smaller scheduled payments.
Term loans can be amortizing, or they can be non-amortizing. In both cases, the borrower (the business) and the lender agree to the terms of the loan before money is exchanged. This agreement will include the principal borrowed, the interest rate and structure, the term length of the loan, as well as the structure of each periodic payment over the lifetime of the loan.
With amortizing loans, the periodic payments (usually monthly or quarterly) that the business makes back to the lender are a mixture of both the principal and the interest. As scheduled, the principal outstanding will decrease with each periodic payment made. These payments are in effect repaying a small portion of the loan and the full amount will have been repaid when the loan’s term length has been reached.
With non-amortizing loans, the lender and borrower will also agree to regular payments, but the payments won’t include the principal amount borrowed. So, the periodic payments that are regularly made throughout the lifetime of the loan are a portion of the interest the borrower will pay on the loan. The principal amount will be repaid at the end of the loan.
With non-amortizing term loans, the periodic payments (monthly or quarterly) will be smaller than they otherwise would be because they don’t include a portion of the principal. The borrower will have to repay the principal in full at the end of the loan term.
It’s important to know what proportions of a loan are principal and interest because the interest payments are tax deductible.
As a side note, amortization for purposes of this guide specifically refers to paying back debt (loans). However, amortization as an accounting term, can also refer to the process of lowering the value of intangible assets (like goodwill) over time, similar to how depreciation works for tangible assets (like commercial real estate). To learn more about goodwill and how it is amortized, we recommend this guide.
The three most common types of repayment options for term loans are reducing, balloon payments, and bullet payments. These loans are typically structured so the borrower makes monthly or quarterly payments on the loan. However, as you will see below, these loans can be structured quite differently so the make-up of these monthly or quarterly payments will vary based on the loan structure.
Reducing repayment loans are structured so that the payments the business has to make back to the lender are a mixture of both principal and interest. Reducing repayment loans are a type of amortizing loan. These types of loans are what most people think of when they think of a traditional loan. With these loans, the business will normally make equal reductions to the outstanding principal with each periodic payment (usually monthly or quarterly) with the interest calculated on the remaining balance for each period. These loans can also be structured so the interest is front-loaded, like in a residential mortgage.
Balloon payments are another way that term loans are commonly structured. With balloon payments, there is also a blended payment structure (like in reducing loans) however, the final payment in a balloon payment is going to be substantially larger than the other payments were. With balloon payments, the equal periodic payments over the life of the loan only partially amortize the loan. The difference here being the final large payment due at the end—called the balloon payment.
So, the periodic payments on a balloon payment structure would be substantially less than on a reducing loan (which is amortized fully), but the last payment on a balloon payment structure would be substantially higher than on a reducing loan. Balloon payment term loans are amortizing, but only partially amortizing—the remainder due in the final, larger balloon payment at the end.
These types of loans require the borrower to be able to make that larger final payment at the end of the loan, but also require smaller payments over the course of the loan (before that final payment).
The third way term loans are commonly structured is with bullet payments. Term loans structured as bullet payments are non-amortizing loans. With a bullet payment structure, only the interest is paid back (usually in quarterly payments) over the length of the loan, but the final payment is for all of the principal borrowed. So, if a business borrows $100,000 at 10 percent interest over 5 years, the periodic payments they’re required to make are only of a portion of the interest on the loan—the principal is paid back in full at the end of the loan.
So, the monthly or quarterly payments here are smaller than they would be with either reducing or balloon payment loans, but the final payment is the largest—accounting for all of the principal amount borrowed.
For all types of repayment structures, there will be application and maintenance fees associated with the loan as well.
To understand interest in term loans we need to understand how these rates are determined. In term loans, the interest rate will be either a fixed rate or a variable rate.
With fixed rate loans, the interest rate will stay the same and won’t fluctuate over the lifetime of the loan.
With variable rate loans, the interest follows a reference, such as prime, or LIBOR, and will fluctuate over time with these reference rates.
Fixed rate loans protect borrowers from rising interest rates, since any changes in rates won’t affect the interest rate paid on the loan. If interest rates skyrocket, the amount the borrower owes stays the same. Variable interest rates protect the borrower from falling interest rates, because if interest rates go down, then the borrower will pay less on the loan than they would a fixed rate loan at the previously higher rate. Meaning, if interest rates went down 2 percent, then the borrower would pay less in interest on the loan than they would if they had agreed to a fixed interest rate loan.
Term loans can be secured or unsecured—the distinguishing factor is whether or not the business borrowing money will put up assets as collateral to back the loan or not.
Secured Loans are loans made to a business when the business puts up assets (such as real estate) as collateral that the lender can claim in the event that the business defaults on the loan. In the event that the business is unable to pay back the money it was lent, the lender can claim the assets the loan was secured against as payment. Securing loans with collateral is a method of making the lender’s investment (lending money for expected interest) more secure.
Unsecured loans are made when the lender perceives the business (borrower) to be a low credit risk and doesn’t require the business to put up any collateral against the loan. Generally, the interest rate on unsecured loans is a little higher than loans with significant collateral in the arrangement. Unsecured term loans are normally made to borrowers with a long-term proven track record of success, strong financials, and the business is considered very creditworthy.
It’s also important to note that from the lender’s perspective, while securing a loan with collateral makes the investment more secure, it doesn’t turn a bad borrower into a good one.
