A term loan is a loan of a fixed amount that a lender provides for an agreed period, from about one year to ten years or more, and that the borrower repays according to a set schedule. The money is usually drawn in full at the start, or in a small number of tranches, and amounts repaid cannot be borrowed again. Businesses use term loans to buy equipment or property, fund acquisitions, refinance existing debt and pay for other long-lived investments.
Term loans are the counterpart of the revolving credit facility, which can be drawn and redrawn, and the two are often packaged together in one loan agreement. Small term loans are made by a single bank; large ones are spread across many lenders through loan syndication. In leveraged finance, term loans are commonly split into a bank-held "Term Loan A" and an institutional "Term Loan B".
Term loan in plain terms
A term loan works much like a car loan for a business. The company borrows a lump sum once, uses it to buy something that will help it earn money for years, and then pays the lender back in instalments until the debt is gone. Every payment includes interest, the price of borrowing, and usually some of the original amount.
The key difference from a revolving facility is that the money cannot be reused. Once a payment has been made, that part of the loan is closed for good. This suits purchases that happen once, such as a new factory machine or buying another company, where the borrower knows how much it needs and roughly how long it will take to repay from future profits.
How a term loan works
The loan agreement sets the amount, the availability period during which it can be drawn, the final maturity date, the interest basis and the repayment profile. Interest may be at a fixed rate or floating, set as a margin over a reference rate such as SOFR, SONIA (which replaced LIBOR for most new loans by 2023) or EURIBOR. Borrowers with floating-rate loans often fix their cost by entering an interest rate swap.
A delayed-draw term loan gives the borrower the right to draw within a set window, often to fund planned acquisitions or capital spending, and usually carries a ticking fee on the undrawn amount until it is used.
Repayment profiles
- Amortizing. The borrower repays principal in regular instalments so that the loan is fully repaid at maturity. The payments are set out in an amortization schedule.
- Bullet. Only interest is paid during the life of the loan and the whole principal falls due at maturity, a structure described in bullet repayment.
- Balloon. Small regular repayments are made, leaving a large final payment, as with balloon payments.
- Cash sweep. Some leveraged loans require a share of excess cash flow each year to be used to prepay the loan, on top of scheduled payments.
Term Loan A and Term Loan B
In the leveraged loan market, especially for companies owned by private equity firms, the two main forms have different investors and terms:
| Feature | Term Loan A (TLA) | Term Loan B (TLB) |
|---|---|---|
| Main lenders | Banks | Institutional investors such as CLO funds and loan funds |
| Typical tenor | About 5 years | About 6 to 8 years |
| Amortization | Substantial, often equal instalments | Nominal (often 1% a year), most repaid at maturity |
| Covenants | Maintenance covenants tested regularly | Often covenant-lite |
| Pricing | Lower margin | Higher margin, sometimes with a rate floor |
TLBs are usually secured on the borrower's assets and rank alongside the RCF as senior secured debt in a leveraged buyout, while riskier layers such as mezzanine financing sit below them.
Covenants, security and risk
Lenders control risk through security over assets, guarantees from group companies and covenants. Maintenance covenants, such as a maximum leverage ratio or a minimum debt service coverage ratio, are tested at regular intervals. Incurrence covenants apply only when the borrower takes a specific action, such as borrowing more or paying a dividend. A breach normally allows the lenders to demand repayment, although in practice most breaches end in a waiver, a reset of the tests or a restructuring.
For the borrower, the main risks are refinancing risk on loans with large final payments, interest rate risk on floating-rate loans, and prepayment fees or "make-whole" amounts if it wants to repay early. For banks, term loans are measured for impairment under IFRS 9 or the US current expected credit loss (CECL) standard, ASC 326, using estimates such as the probability of default.