Definition: The Term Loan is the primary source of long-term debt raised by the companies to finance the acquisition of fixed assets and working capital margin. It is also called as a term finance which means the money raised through the term loans is generally repayable in regular payments i.e. fixed number of installments over a period of time.
Advantages of Term Loan
- Interest on debt is tax-deductible, whereas the equity or preference dividends are paid out of profit after tax.
- There is no dilution of control of the management, since, in the debt financing, the lenders have no right to vote.
- The lenders are not entitled to the profits of the firm as they are only paid the principal and the interest amount.
- An issue cost of debt is less expensive as compared to the preference and equity capital.
- The maturity of the debt instrument can be altered with respect to the funds requirements in the firm.
- Generally, it is easier for the management of the firm to communicate the proprietary details to the private lenders than to a public capital market.
Disadvantages of Term Loan
- The firm is legally obliged to pay the fixed interest and principal amount to the lenders, the failure of which could lead to its bankruptcy.
- The debt financing, especially the term loans, raises the financial leverage of the firm, which in turn raises the cost of equity to the firm.
- If the inflation rate touches the extremely low levels, then the real cost of debt will be more than expected.
Now the question may arise, that how the term loan is different from the bank’s short-term loan? Well, the bank’s short-term loans are employed to finance the short-term working capital requirements, and it recovers its full cost in less than a year. The banks or financial institutions give rupee loans as well as a foreign currency term loan.
The rupee term loan is generally given directly to the organizations for setting up new projects or buying new capital assets. Whereas, the currency loan is given to meet the expenses incurred in importing the machinery or equipment or paying the fees against the foreign technical know-how. The term loan is typically a secured borrowing, as the assets against which the loan is raised is called the prime security while the other assets may serve as a collateral security.