External sources of finance come from outside the business. Long-term bank loan belongs to external sources of finance. When businesses need to use the money in the long term (more than five years), this creates the need for long-term finance.
The amount of long-term finance needed for buying Fixed Assets, or Non-Current Assets, with a relatively low value, such as vehicles, will be small. While the amount of long-term finance needed for buying Fixed Assets, or Non-Current Assets, with a relatively high value such as new machinery for the assembly line will be large.
1. Long-term bank loan
A long-term bank loan is provision of finance by the lender to the business for a long period of time. The lender is usually a commercial bank. The amount borrowed is paid back in installments over a predetermined agreed period of time usually 10, 20 or 30 years.
The recipient of a long-term bank loan incurs a debt and is liable to pay interest on that debt until the whole amount is fully repaid. So, the borrower must repay the principal amount borrowed plus interest.
How much is interest on a bank loan?
The interest rate on a long-term bank loan typically range between 2% and 6%. This is usually much cheaper than short-term finance such as an overdraft or credit card debt. The better relationship the business has with its bank, the more attractive interest it can get. Interest will also depend on the total amount borrowed with higher amounts coming with lower rate of interest.
Fixed or variable rate of interest?
Interest charges imposed on the amount borrowed can be either fixed or variable, depending on the agreement between the bank and the borrower.
A. Fixed rate of interest
A fixed rate of interest will not change, no matter what economic factors occur in the country. The business will be certain how much interest it has to pay over the whole lifespan of the loan. Fixed rates provide more certainty and reduce the risk to the business of increased costs, if interest rates set by the central bank rise. If interest rates in the country decrease in the future, the loan will turn out to be expensive because the loan was agreed at the time of high interest rates.
B. Variable rate of interest
A variable rate of interest can change (rise or fall) depending on economic factors in the country, mainly the level of interest rates set by the central bank. The business will not be certain how much interest it has to pay over the whole lifespan of the loan. Variable rates provide less certainty and increase the risk to the business of increased costs, if interest rates set by the central bank rise in the future. If interest rates in the country drop, this change will make the loan less expensive overall.
Collateral is required for a long-term bank loan
Any borrower of a long-term bank loan must provide a collateral against any money borrowed. A collateral is attached to the loan as security in the form of another asset. This means that the bank is given the right to sell that asset when the borrower is not able to repay the debt. If the borrower fails to make payments, the business will lose collateral.
Is it easy to get a long-term bank loan?
Long-term bank loans tend to have strict and bureaucratic approval process. Banks have very stringent requirements making the loan quite difficult to get without being a well-established business organization.
Can a small business apply for a long-term bank loan?
Small businesses find it quite difficult to obtain long-term bank loans. Businesses with fewer assets to act as security are seen as a greater risk by the commercial banks.
If a small business manages to finally obtain a loan, then it may be asked to pay higher rates of interest than what larger businesses are charged. This is how lenders hedge against higher risks of smaller borrowers not being able to repay their loans when due.
Can the long-term bank loan be repaid earlier?
Generally, yes, but there might be strings attached. Based on different conditions, some bank loans come with prepayment penalties amongst other fees for early repayment. This means that even if the business comes across a large amount of cash and wants to pay the bank loan earlier, it may be cheaper to simply keep on paying interest. Interest is TAX-deductible, hence lowers Corporate TAX.
In short, a bank loan is the most common source of external finance used by businesses for future growth. Long-term means that the loan does not have to be repaid for at least five years.
