Getting a commercial loan is not easy, especially for first-time applicants. The process of applying for a commercial loan will feel very different than any other loan application process you may have experienced in the past. And your reasons for needing a commercial loan may be very different from reasons that you’ve had for taking out loans in the past. If you are contemplating a commercial loan to grow your business, this article will explain everything you need to know about commercial loans, including what they are, what you’ll need to apply for one, and how they differ from other loans.
What Is a Commercial Loan?
A commercial loan is borrowed to a small or mid-sized business from a financial institution to address growth or business expansion financial needs. The amount acquired can be used to buy equipment, office furniture, and space or finance everyday operational costs.
To get a commercial loan, you should approach a financial institution of your choice with collateral, which the lender will take over if you cannot pay the loan. What’s more, there are different types of commercial loans. Below are a few types:
- Business line credit- a business line credit is similar to a credit card. The business qualifies for a maximum amount that you can withdraw as needed. The good thing with this type of loan is that you only pay interest for the amount you have used and not the whole qualifying maximum amount.
- Construction loans- as the name suggests, business owners should channel construction loans to new business constructions. You can use the money to construct new offices or a conference center. You should only use the money to design and build structures that do not exist.
- Equipment financing- depending on your line of business, you might require expensive equipment which you cannot afford to pay for upfront. In such a case, apply for an equipment loan, and the good thing is, the equipment serves as collateral. However, your lender can seize the equipment if you default.
- Commercial real estate loan- if your business is looking into buying a commercial property, a real estate loan is what you should apply for. This type of loan attracts high interest and fees because of surveys, appraisals, and documentation costs. If you cannot afford this loan, you can opt to lease or rent the property you want.
- Commercial auto loan- if your business requires vehicles for operations, then approach your financial institution for an auto loan to help you buy average-sized vehicles like vans, cars, and pickups. Large vehicles like long trucks are better purchased through equipment financing.
- Hard money loans- these are short-term loans issued by private investors at a higher interest rate. A business should only take hard money loans if they are in immediate need of cash and have plans to pay it off within a short duration to cut the high-interest rates.
Who Is Eligible for a Commercial Loan?
Commercial loans are high-risk loans because they can only be paid back through the business revenue, which is at the mercy of the economy and other external factors. For this reason, lenders are stricter on the eligibility criteria of commercial borrowers. To qualify for a commercial loan, you must meet all the lender’s requirements for issuing commercial loans. These requirements include:
1. The Collateral Property Value
The property’s value used as collateral must be worth the commercial loan request. If the business defaults on payments, the financial institution will seize the property and recover its losses.
The bank uses a loan-to-debt ratio to determine whether they can take the property as collateral. This is achieved by dividing the commercial loan amount by the property value and the borrower’s net income. To qualify for a commercial loan, you should have at least 25% equity in the property to be used as collateral. This means that, for example, that a car you just purchased for your business and haven’t begun to meaningfully pay off will not serve as collateral.
2. Collateral Property Income
The lender will also compare the business’s cash flow with the amount you borrow. To qualify for the loan, the cash flow into the business should be 20% greater than the debt. This gives the lender confidence that you will be able to make the monthly payments comfortably.
The bank will ask you for proof of income and expenses in detailed statements. The lender will also want to know if you have savings that you can use to make monthly payments if the business is not doing well.
3. Income and Assets of the Business Owner
The business owner serves as the commercial loan guarantor. Guaranteeing the business means that you will ensure that the loan is paid if the business defaults. For that reason, the lender asks for documentation of personal assets and income. What’s more, your credit score must meet the bank’s requirements.
How Commercial Loans Differ From Other Types of Loans
Commercial loans are different from consumer loans in terms of collateralization, interest rates, source, and loan terms. Understanding these differences may help you understand why the process of applying for a commercial loan feels different than what you’ve experienced in the past. Major banks or the national mortgage lender offer consumer loans. On the other hand, only local banks offer commercial loans, giving the commercial borrower fewer options. Commercial loans are also charged higher interest rates than consumer loans. The rates are even higher if the business borrows from a private investor.
Most home loans are issued for 30 years, unlike commercial loans, which should be repaid within a shorter period, between 5 to 10 years. Lenders prefer to amortize commercial loans over shorter periods to reduce the risk. With home loans, you will usually put at least 20 percent of the total amount as a down payment. Some lenders will even offer the loan with a lower deposit. However, the deposit is higher with commercial loans, especially if you are a first-time borrower.Whether you qualify for a residential loan depends on your credit score and net income. On the other hand, the value and income flow of the property to be used as collateral determines your eligibility for a commercial loan. Finally, the government protects residential loan borrowers more because the Real Estate Settlement Procedures Act regulates the loans. This is not the case with commercial loans, where you can negotiate the loan terms, interest rates, and even documentation with the lender. To stay safe, hire an attorney to review the loan documents before signing