Term loans also referred to as â€˜term financeâ€™ represent a source of debt finance which is generally repayable in more than one year but less than 10 years. They are employed to finance acquisition of fixed assets and working capital margin. The following features of terms loans are discussed here:
(b) Interest payment and principal repayment.
(c) Restrictive covenants.
Term loans typically represent secured borrowing. Usually assets which are financed with the proceeds of the term loan provide the prime security. Other assets of the firm may serve as collateral security.
All loans provided by financial institutions, along with interest, liquidated damages, commitment charges, expenses, etc., are secured by way of:
(i) First equitable mortgage of all immovable properties of the borrower, both present and future; and
(ii) Hypothecation of all movable properties of the borrower, both present and future, subject to prior charges in favor of commercial banks or obtaining working capital advance in the normal course of business.
Interest Payment and Principal Repayment:
The interest on term loans is a definite obligation that is payable irrespective of the financial situation of the firm. To the general category of borrowers, financial institutions charge an interest rate that is related to the credit risk of the proposal, subject usually to a certain floor rate. Financial institutions impose a penalty for defaults. In case of default of payment of installments of principal and/or interest, the borrower is liable to pay by way of liquidated damages additional interest calculated at the rate of 2 percent per annum for the period of default on the amount of principal and/or interest in default. In addition to interest, lending institutions levy a commitment fee on the unutilized loan amount.
The principal amount of a term loan is generally repayable over a period of 6 to 10 years after an initial grace period of 1 to 2 years. Typically, term loans provided by financial institutions are repayable in equal semi-annual installments, whereas term loans granted by commercial banks are repayable in equal quarterly installments.
Note that the interest burden declines over time, whereas the principal repayment remains constant. This means that the total debt servicing burden (consisting of interest payment and principal repayment) declines over time. This pattern of debt servicing burden, typical in India, differs from the pattern obtaining in western economies where debt is typically amortized in equal periodic installments.
The latter pattern is relatively more acceptable to borrowers because it does not result in a heavy debt servicing burden in earlier years. It has also been recommended by the International Bank for Reconstruction and Development (popularly called the World Bank).
However, presently financial institutions in India do not follow the scheme of equal periodic amortization. Yet they try to ensure, by suitably modifying the debt repayment schedule, within limits so that the debt servicing burden is not very onerous.
In order to protect their interest, financial institutions generally impose restrictive conditions on the borrowers. While the specific set of restrictive covenants depends on the nature of the project and thee financial situation of the borrower, loan contracts often require that the borrowing firm:
1. Broad-base its board of directors and finalize its management set-up in consultation with and to the satisfaction of the financial institutions.
2. Make arrangements to bring additional funds in the form of unsecured loans/deposits for meeting overruns/shortfalls
3. Refrain from undertaking any new project and/or expansion or make any investment without the prior approval of the financial institutions
4. Obtain clearances and licenses from various government agencies.
5. Repay existing loans with the concurrence of financial institutions
6. Refrain from additional borrowings or seek the consent of financial institutions for additional borrowings
7. Reduce the proportion of debt in its capital structure by issuing additional equity and preference capital
8. Limit its dividend payment to a certain rate or seek the consent of financial institutions to declare dividend at a higher rate
9. Refrain from creating further charges on its assets
10. Provide periodic information about its operation
11. Limit the freedom of the promoters to dispose of their share holding
12. Effect organizational changes and appoint suitable professional staff.
Term loans differ from short-term bank loans which are employed to finance short-term working capital need and tend to be self-liquidating over a period of time, usually less than one year.