Tips for understanding and successfully acquiring commercial loans
Loans make millions of purchases like dream homes and new cars possible each year. They can make a huge difference for small businesses looking to expand their operations and move up to a new level of service and products. Businesses typically seek a type of loan called a commercial loan. A commercial loan requires a business to enter into an agreement with a lender (e.g. a bank or a mortgage broker) to receive funds and then repay them within an agreed timeframe. These types of loans are frequently used for capital expenditures or other operational costs that a business can’t afford on its income alone. But how do commercial loans work?
A commercial loan can be a lifeline for a small business, but did you know that 50% of business owners and real estate investors are denied, turned away, or not even approved for the amount of financing that they’re seeking from local lenders?
Like any part of your business, it’s important to understand the purpose and details behind a commercial loan. The more you know, the better prepared you’ll be if you apply for a commercial loan. Before knowing how do commercial loans work, we need to know what are the types of it.
Commercial Loan Types:
There are a few types of commercial loans available to businesses.
Small Business Administration Loans
First up are Small Business Administration (SBA) loans. These loans are offered by the SBA, a federal government agency tasked with providing resources that help small businesses thrive in the United States. As we mentioned, it can be difficult for small businesses to be approved for financing through traditional lenders like banks. The SBA seeks to reduce that borrowing risk by providing a few loan programs for different types of business needs. SBA loans include counseling and education resources, competitive rates, lower down payments, and no collateral needed for some loans.
Housing and Urban Development Loans
Next are U.S Department of Housing and Urban Development (HUD) loans. While HUD is best known for offering mortgages for qualifying homebuyers, the department does offer loans for housing-focused commercial enterprises, such as loan programs to purchase, rehabilitate, or refinance multifamily dwellings. This includes structures like apartment buildings and healthcare facilities. These loans are facilities through the Federal Housing Administration division of HUD.
Commercial Construction Loans
Another type of commercial loan is a construction loan. As the name implies, this type of loan provides financing for the renovation or construction of a commercial property. That includes projects such as rehabbing your business’ interior, building a new production facility, or developing property for residential or personal use in a city. Several types of lenders offer construction loans. Unlike other types of loans, construction loans borrowers aren’t given all their funds at once. Construction loans employ a draw system, meaning the borrower must meet certain project milestones in order to unlock all the loan funds. It’s worth noting that as a borrower with a commercial construction loan, you will only pay interest on the portion of the distributed loan proceeds. That means if the total cost of your project is $400,000, but the lender has released only $100,000, you’ll pay interest on $100,000.
Another type of loan available to businesses is a type of short-term financing called a bridge loan. These loans help businesses bridge gaps in financing and provide an option for quick cash flow. Bridge loans, also known as gap financing or interim financing, typically have terms of one or less, close quickly—sometimes in as little as a week—and are often used to cover expenses such as closing costs on real estate. One thing to note is that these loans usually have higher interest rates than other loan products.
Now let’s dive in and know how do commercial loans work by breaking up the process:
1. Commercial Loan Application
It might be tempting to compare a commercial loan to a mortgage. Both loans require borrowers to submit information about their finances, employment, and other relevant details as part of the application process.
But when it comes to commercial loans, lenders and underwriters are looking at different things than your typical credit score, income, and debts. Lenders want to know how risky of a borrower you are, so they’re looking at more than your personal and business finances. They want to understand things such as your experience in managing business assets and if you have reserve money on hand for emergencies and unexpected expenditures. The loan process requires a lot of preparation and planning to be successful. Ultimately, lenders want to make sure that the loan they’re offering makes sense for your situation, and—of course—that they’re going to get their money back.
2. Commercial Loan-to-Value Ratio
One important aspect of commercial loans to understand is the loan-to-value ratio (LTV). That term refers to an assessment of lending risk that financial institutions and other lenders conduct before approving a loan. In general, commercial loans are considered riskier than mortgages, so they tend to require higher down payments or collateral as part of their terms.
For example, if you’re in the property management business and are looking to purchase a six-unit building, it’s likely you’d have a down payment of 25%. On a multi-million-dollar purchase, that amount adds up fast. There are resources you can pursue to help cover this payment, but you’ll still need to put your own money into play as lenders want to see that you have skin in the game as well (remember, it’s all about risk). SBA loans mentioned above do have options that let qualifying commercial borrowers put less than 20% down.
3. Commercial Loan Terms
Every loan comes with terms and commercial loans are no different. The terms will vary depending on the lender you’re working with. If you go to a local lender, you’re most likely going to be offered a 15-year loan that has a five-year adjustable-rate mortgage (ARM) or a balloon payment. An ARM means that the payment is spread out over 15 years, but the rate is only locked in for the first five years. A balloon payment refers to a larger-than-usual one-time payment at the end of the loan term. At the time the payment comes due, you’ll need to refinance or pay off the balance.
It’s always smart to stay on top of your commercial loans or go through a broker who has options that extend longer than 15 years. A commercial broker is going to be able to find lenders who offer terms such as 30 years or have an option to only pay interest. This can greatly impact your monthly cash flow.
Commercial Loan Interest Rates:
Another element of commercial loans you should understand is their interest rates. Like traditional mortgages, commercial interest rates can be calculated in a variety of ways depending on the lender’s internal cost of funds. The average interest rate on a commercial loan ranges from 2.2% to 18%. The interest rate you pay depends on the type of loan you choose, your qualifications as a borrower, and the type of project you’re financing. The most common way lenders calculate interest rates is by factoring in elements such as credit score and the loan term length.
Commercial loans can finance projects of all sorts, from the purchase of a single-family property that will be converted to a rental to buying a 100 unit apartment complex to purchasing land for development. Different loans have different requirements so it’s important to find one that will cover the type of construction you want to do, whether it’s rehabbing an existing structure or building something new.
The key takeaway here is that not all banks will finance everything, so finding a lender who is familiar with your industry and your property type is going to be the key to success when you want to continue growing your business.
Still have questions about how do commercial loans work? Let us know and we will answer your questions!
For more information about commercial loans, watch this video or read our guide: Commercial Loans: Everything You Need to Know.