How Do Commercial Loans Work?

How Do Commercial Loans Work?

How Do Commercial Loans Work?

Small business loans, specifically commercial loans, are designed to help businesses borrow money for any number of reasons, from working capital to purchasing equipment or real estate. 

Understanding how these loans work can help you make a smarter decision when your business needs a loan. 

What is a Commercial Loan?

The term “commercial loan” may sound intimidating if you’re not familiar with it. If you’re wondering, “What is commercial lending?” it simply refers to loans made to a business for business purposes. Since businesses are engaged in commerce, these loans may be referred to as commercial loans— or small business loans. 

Cash flow is a constant challenge for many small businesses. These loans offer a way for businesses to borrow money and pay it back later, hopefully as the business makes money. 

How Does A Commercial Loan Work?

There are many types of business financing options that might fall under the commercial lending umbrella.

Most commercial lenders look at one or more of the following criteria when underwriting (evaluating) business loan applications:

  • Creditworthiness: personal and/or business credit may be checked
  • Time in business: most lenders prefer to lend to established businesses; startup loans are harder to get
  • Revenues: lenders will want to ensure the business can repay the loan and may require a certain amount of annual or monthly revenue that must be confirmed by business bank statements.

Beyond that, qualifications may vary substantially. For example, depending on the lender’s policies you may need: 

  • A down payment or collateral
  • To operate as a business entity (LLC or corporation for example)
  • A business plan and/or financial statements showing how you’ll use the funds

Again, not all lenders have these additional eligibility requirements. Nav can help you find financing options based on your qualifications.

What are the Benefits of a Commercial Loan?

Getting a commercial loan can give small business owners a number of benefits and advantages. 

One of their most important benefits is many commercial loans are tied to the business, rather than the personal finances of the owner. (Any non-commercial loan is a personal loan, and that means it will almost certainly carry a personal guarantee.) 

Commercial loans rarely appear on the owner’s personal credit reports, and if the loan is reported to commercial credit agencies, they can help establish business credit

That’s not to say a personal guarantee won’t be required for a small business loan. Some commercial loans do require them, in particular, most SBA loans require PGs. 

Potential Disadvantages of a Commercial Loan

While commercial loans can open new opportunities to business owners, there are some potential downsides. 

First, the application process can be extremely long, and there’s usually a lot of paperwork involved. They can also be less flexible than other types of lending, which can be a disadvantage if you have unpredictable cash flow. 

Finally, as with any loan, there is always the risk of default, which would affect your business credit score and potentially trigger consequences like legal challenges. Commercial loans are typically secured loans, so defaulting could also mean losing any collateral you’ve provided. 

What are Ideal Business Uses for a Commercial Loan?

Business loans can be used successfully in any number of ways: 

  • Expanding the business into new markets
  • Purchasing new equipment
  • Moving into new property
  • Refinancing or consolidating debt
  • Helping with cash flow and working capital
  • Acquiring another business

Commercial Lenders

A commercial lender can be a traditional lender like a bank or credit union, an online lender, a nonprofit Community Development Financial Institution (CDFI) or even an independent investor, depending on the type of financing you are looking for. The SBA also guarantees commercial loans made by approved financial institutions.

What Types of Commercial Loans are There?

There are various types of commercial loans available to businesses, and often the right loan can be determined by the intended business use, although there are several commercial financing options that can be used for a number of purposes—think of them as general-purpose working capital loans. Others are specifically designed for real estate purchases or other investments.

Multi-Purpose Commercial Loans

Some loans must be used for specific purposes, while others, like the following, can be used for a variety of business expenses, such as hiring employees, buying equipment, smoothing out cash flow or even purchasing commercial property. 

Business Term Loans

If you need to borrow a specific amount of money for a specific project, a term loan is often ideal. You’ll get a lump sum of money that is usually repaid over a specific period of time. In other words, the repayment terms are predictable. 

Business Line of Credit

While a term loan provides access to a single lump-sum of cash, a line of credit offers access to revolving debt (or revolving line of credit), similar to a credit card. For instance, if approved for $25,000, you’ll be able to access up to $25,000 for the duration of the draw period, make monthly payments on that balance, access the credit again, and you’ll only be charged interest on what you use.

You can use and repay the funds as often as you wish during the draw period, but modern business lines of credit typically come with a defined term. Once the term has expired, you will no longer have access to the credit line unless you reapply.

A line of credit is often ideal for businesses who need to account for seasonal revenue disruptions, purchase inventory or supplies, or account for other expected or unexpected gaps in cash flow.

Lines of credit can be obtained from online lenders, traditional lenders like banks or credit unions, and even some private lenders. As such, interest rates, terms, and amounts can vary. Typically borrowers may be able to access between $5,000 and $250,000 but there are $1 million plus lines of credit for well-qualified businesses. 

Business Cash Advance

Although it’s not technically considered a loan, this type of financing is popular with businesses that need money quickly and have lots of credit and debit card sales. 

Here you’ll get a lump sum advanced to your business based on previous revenues. You’ll then typically pay back that advance on a daily, or perhaps weekly, basis out of future revenues. This type of financing tends to be on the more expensive side and offers a short-term solution. 

Business Credit Cards

Business credit cards can be a valuable (and flexible) financial tool for a small business owner. Business credit cards can make it easier to manage and track spending, provide additional working capital at a moment’s notice, and often come with perks like cash back or travel rewards

Credit cards have few usage exceptions—you can choose how you spend the funds—which makes them flexible enough to handle many spending needs. 

However, if you’re considering a credit card to manage expenses or for a cash advance, there are a few things to keep in mind. In some cases, credit card interest rates can be high, particularly if you have average or below-average credit. As such, they may not always be ideal for carrying large balances.

Many business credit cards require good personal credit scores to qualify. But income can come from multiple sources, not just the business, so they may be available to startups.

If you plan to carry a balance, look for a low-rate card. (There are even ones that offer a 0% introductory APR.) If you pay in full, look for a credit cards that offer rewards, as these can help you earn points, cash back, or miles when making everyday business purchases.

Vendor Credit

Though this may not be a commercial loan in the typical sense, it can still be extremely valuable to your business. What’s more, payment terms from your suppliers are one of the most underutilized forms of commercial credit available to a small business owner today. And, in challenging times like we’re experiencing right now, vendor credit can be a powerful tool to help you free up cash flow for other expenses.

Vendor credit allows you to purchase goods or services from a specific vendor on credit. Though many vendors offer net-30 accounts, meaning you must pay within 30 days, there are also vendors that offer net-60 and net-90 days. Many vendors also offer a discount to those business owners who pay early (within 10 days, for example). 

This type of arrangement frees up working capital and gives you time to turn goods or services into tangible profits before you need to pay the invoice. It’s also important to note that if your suppliers report your good credit history to the appropriate business credit bureaus (Dun & Bradstreet, Experian, and Equifax), vendor credit can also help you build a strong business credit profile. And, better business credit will make it easier to secure affordable financing in the future.

Find net-30 vendors that help build business credit here

SBA Loans

SBA loans are guaranteed by the U.S. Small Business Administration but originated by participating lenders (except for SBA Disaster loans). There are numerous loan programs available through the SBA, but the SBA 7(a) loan program and the 504/CDC loan program are the most popular.

To be eligible for these loans you must be considered a small, for-profit business that operates within the U.S., according to the SBA guidelines.  

SBA 7(a)

The SBA 7(a)  loan is considered the most popular SBA loan and can be used for a variety of working capital needs. This includes purchasing equipment, managing operational expenses, purchasing land, and consolidating debt.

SBA loans are available up to $5 million (loans under $30,000 are not common within the 7(a) loan program and are usually covered with an SBA Microloan). Working capital, inventory, or equipment loans carry terms of 10 years, while real estate loans and other SBA loans may carry terms as long as 25 years.

SBA 504/CDC loans

This particular type of SBA loan is offered in conjunction with financial institutions and Certified Development Companies (CDCs), which are non-profit companies that promote economic growth. Typically the borrower puts up 10%, a conventional lender loans 50% and the CDC / 504 lender lends 40%.  

Approved applicants for these real estate and development loans can terms typically ranging from 10 to 20 years with a fixed rate.  

Unlike SBA 7(a) loans, which offer a bit more flexibility, 504 loan proceeds must be used for one of the following:

  • Purchase an existing building
  • Purchase land or improving lands (e.g., parking lots, grading, landscaping, etc.)
  • Construct a new facility
  • Modernize, renovate, convert, or existing facility
  • Purchase long-term machinery
  • Refinance expansion or renovation debt.

Commercial Real Estate Loans

The next category of commercial loans we have centers around real estate lending. These loans are specifically to purchase or remodel investment properties.

Long-Term Commercial Loans

Much like its consumer counterpart, this type of commercial mortgage loan allows you to purchase property.  A business mortgage or commercial real estate loan, however, can only be used to purchase income-earning property. This includes things like retail shops, office space, hotels, multifamily units, etc.    

Long-term fixed interest rate mortgage loans are typically available for 5 to 20 years. In addition, commercial mortgages typically come with a number of upfront costs including origination fees, appraisal fees, survey fees, etc.

In addition to fees, most lenders will also require borrowers to put down a 20% to 30% down payment based on the purchase price of the property.  

Hard Money Loans

A hard money loan is a short-term loan used to purchase real estate, frequently with the goal of investment. For that reason, this type of loan is most often leveraged by individuals hoping to invest in and flip a property.

Unlike mortgages, these loans are not originated by traditional lenders; instead, funds typically come from private investors—or hard money lenders. Another difference worth noting is that eligibility is typically based on the property value, not the applicant’s creditworthiness. The assumption is that if the borrower can’t make payments, the lender will use the property as collateral, so he or she can take possession of the property in case of default—and then sell it to recoup the loan.

These loans are notoriously more expensive than other options, with higher variable interest rates and balloon payments common. As such, they should be used with caution.

Why use one at all? Despite high interest rates, they are considered to be a much faster pathway to funding when compared to other real estate loans. And, since they are based on the value of the property and not an applicant’s credit history, they may be easier to obtain in some cases.

Real Estate Bridge Loan

Fundamentally, a business bridge loan can be any short-term loan (from a few months to a few years) that provides quick access to funds and is used to “bridge” a gap in expenses. As such, this term is frequently used to refer to a number of lending situations.

In this case, a real estate bridge loan provides the capital necessary to make a commercial real estate purchase without enduring the long process often associated with long-term business financing like mortgages. These may come in handy when taking advantage of a real estate opportunity, moving your business, or undergoing a renovation that will increase the value of your property.

Ideally, bridge loans are repaid quickly when pending capital becomes available. However, in some cases, borrowers will need to refinance their bridge loan through another loan, be it a traditional loan, an SBA loan, or another, more affordable loan.

Construction Loans

As the name implies, this type of loan is used to fund new construction or repairs and renovations to existing property. Funds can be used to cover the costs of land or property, materials, and labor.

Unlike other types of commercial loans that provide borrowers with a lump sum of money, a commercial construction loan is released in increments. Borrowers must usually work within a draw schedule that specifies specific milestones upon which more funds will become available.

Blanket Loans

A blanket loan is a funding option that caters to investors with multiple properties. Essentially, these commercial loans allow borrowers to consolidate numerous mortgages into one. This makes payment easier and can reduce administration costs.

Another benefit of this type of loan has to do with construction — specifically the impact a lien can have on impending construction efforts. Frequently, if a builder or developer wants to undertake construction on a property under a mortgage, she will be unable to secure a loan due to existing liens on the property (e.g., the mortgage).

If the property owner has enough equity built up in other properties, she can exercise a release clause that removes the lien from the property in question.

These loans are available through traditional and commercial lenders, and an increasing number of online lenders are beginning to offer blanket loans. 

Using a Commercial Loan Calculator 

One of the best ways to ensure that you’re making the best decision as it relates to your real estate investment is to use a commercial loan calculator.

While there are numerous loan calculators that can help you determine the general cost of a loan, a commercial loan calculator is designed to account for a specific variable, like amortization terms, a balloon payment, and principal and interest payments.

In addition to comparing lenders, a commercial loan calculator will also allow you to compare various lending scenarios based on loan amounts, terms, and rates.

Frequently Asked Questions

Let’s try to address any lingering questions you may have about commercial loans and how they work.

How are Commercial Loan Rates Determined?

With the exception of hard money loans, most lenders base commercial loan rates on two primary factors: your business finances and business or personal credit qualifications. If the loan is specifically for a real estate purchase, construction, or renovation, then the lender will also take into consideration the property value for which the loan will be used.

When applying for a commercial loan, the lender may review your business credit report, which is used to determine risk—in other words, how likely you are to repay the debt. Similarly, even though the loan is for your business, the lender may also take into consideration your personal credit score.  

For that reason, it’s best to check both your personal and business credit before you apply for a loan. 

Just as some types of personal loans may consider an applicant’s debt-to-income ratio, a commercial lender may look at your company’s “debt service coverage ratio” as part of the credit approval process. DSCR is determined by dividing your net operating income (NOI) by your total debt service, which includes the principal balance as well as the interest to be paid.

Depending on the type of loan, the lender may also ask to see documentation, such as your financial statements (balance sheet, profit and loss statement), tax returns, business checking account statements, and more.

How Do You Qualify for a Commercial Loan?

As mentioned earlier, loan eligibility requirements for a commercial loan vary. Most lenders prefer your business to be at least one to two years old, and some minimum personal and/or business credit scores. Some may require collateral.

What Deposit is Required for a Commercial Mortgage?

Some (but not all) lenders specializing in commercial real estate loans may require a 20-30% down payment on the loan. SBA 504 loans require a 10% down payment.

What is the Down Payment for a Commercial Loan?

Some loans require down payments, and others do not. There are many small business loans that don’t require a down payment but they may require a personal guarantee, or collateral may be required.

Real estate loans, as you see in the question above, may require 20-30% as a down payment, but other loans may require some other form of collateral or none at all.

A commercial loan could be the financial support you need to boost your business or keep it afloat during hard times.

How Long Do You Have To Pay Off A Commercial Loan?

Commercial loan repayment periods vary from as short as a few months to as along as 25—30 years. Most loans will have repayment periods between 1—10 years. 

What Is A Good Interest Rate On A Commercial Business Loan?

Interest rates on small business loans have been rising in recent years, due to the Federal Reserve raising interest rates in response to inflation. Whether you can get a low interest rate will depend on interest rates in the economy, as well as your qualifications. 

You may want to compare the interest rate you’re offered to SBA loan rates to get an idea of how much more you’ll pay, but keep in mind those loans go to well-qualified borrowers. If you need money more quickly, or if you have lower revenues or credit scores, you’ll likely pay more. 

What Is The Difference Between Business Commercial And Residential Loans?

Commercial loans are used to purchase property that will be used for business purposes, while residential loans are used to buy a home the owner intends to live in.

Commercial property loans are considered riskier than residential property loans because businesses have a fairly high failure rate. As a result commercial loans often carry a higher down payment requirement (20% or more), and other financial requirements such as good credit and the ability to cover the mortgage payment. 

Repayment terms may be different as well. While the loan payment may be calculated over a 30-year period like a residential mortgage, the lender may require it to be paid off in 15 or 20 years, with a balloon payment required for the remaining balance. 

This article was originally written on April 30, 2022 and updated on March 20, 2023.

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