Comprehensive Guide to Commercial Loans
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Growing a business takes ingenuity, dedication, and passion but few get off the ground without another important component: money. Funding is necessary for both new and old businesses to survive and expand, but not everyone has the cash on hand to make that next big jump in their business journey. In fact, the U.S. Small Business Administration found that about one-third of new companies started with $10,000 or less in capital. So how do businesses get access to additional money they need? Many apply for commercial loans.
Understanding Commercial Loans
Businesses in need of financing can pursue a type of loan called a commercial loan. Like a personal 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 businesses can’t afford on their income alone.
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.
Types of Commercial Loans
There are a few types of commercial loans available to businesses that cover projects such as renovations, buying new equipment, and property purchases. It’s important to find a lender that can present options to you and help you decide which is best for your business.
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.
- The 7(a) Loan Program is the SBA’s most common loan program. This loan option is typically used for purchasing supplies such as furniture and fixtures, refinancing, and providing short- and long-term capital. The max amount you can take out a 7(a) loan for is $5 million.
- The 504 Loan Program aims to provide up to $5 million in financing for major assets that encourage business growth and job creation. This includes the construction or purchase of land, buildings, and equipment.
- The Microloan Program seeks to make a big impact with small loans. The program offers loans up to $50,000 to help small businesses start up and expand.
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 such as senior care homes.
These loans are facilitated through the Federal Housing Administration division of HUD. FHA loans are backed by the government, which in turn decreases the level of risk lenders associate with you. Less risk means lower loan interest rates and more money staying in your pocket.
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. Some construction loans do have a minimum project cost of $125,000 as part of their requirements.
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.
Bridge Loans
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.
Benefits of Commercial Loans
There are several benefits to using commercial loans compared to other types of financing—some types of which can’t be accessed by small to medium businesses such as bonds. The loan itself provides access to cash to cover expenses.
The process of getting a commercial loan can be tedious but is easier than raising funds through other means, such as selling equity in the business or going through bond markets.
The costs and regulatory hurdles associated with the latter two methods make a commercial loan a more viable option for financing.
Raising money through equity also comes with another drawback. When businesses do this, they give up equity (percentage of ownership) in exchange for funds. A commercial loan allows an owner to raise money without diluting their stake in the business.
The Commercial Loan Application Process
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.
Here’s a step-by-step overview of what you can typically expect with the commercial loan process:
1. Pre-approval
The commercial loan process begins when you meet with a lender, who will start evaluating the financial history and income of your business. This is called the pre-approval stage. Additionally, the lender will review any existing debt held by your business and the reason why you are seeking a loan. This information gathering helps give your lender an idea of how much the business would be able to borrow and how risky of a borrower they think you might be.
2. Loan application
After you’ve completed the pre-approval process, it’s time for more paperwork. You’ll need to complete and submit a loan application. As part of the application, you’ll likely need to supply financial statements or similar documents dating back at least three years. Again, your lender is looking for evidence that you’ll be able to repay the loan.
3. Application review
Once your application is submitted, your lender will review these documents as part of a due diligence process. That means they will investigate things such as credit history, any collateral you can provide for the loan, the current and projected income of your business, and other relevant information. Your business will undergo a financial analysis as part of this step so be sure to have documents prepared and ready to go to help keep the process moving forward and moving smoothly.
4. Underwriting
If your loan application gets the green light from a lender, then a formal credit application is submitted to an underwriter or loan committee. The underwriter or committee reviews all submitted information and makes a decision on whether to approve or deny the loan. This part of the process can take up to a week, and reviewers may request more documents so be prepared to send additional documentation as soon as possible when requested.
5. Term sheet
If your loan is approved by the underwriter or loan committee, then the next step is receiving your term sheet. This sheet outlines a lot of information, including the amount of financing, collateral, fees, use of the loan, and the interest rate. After reviewing the term sheet and signing a letter of intent, you also need to pay for reports compiled by third parties, such as an appraisal.
6. Loan package and closing documents
After your third-party reports are completed and paid for, your loan application package is resubmitted to the underwriter for final approval. If your loan is approved, it’s time to sign on the dotted line. If you have the funds, you can use a closing agent such as an attorney to handle all closing documents and complete any remaining paperwork.
Related Article: How Do Commercial Loans Work?
What should I know about the 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, but you’ll need to meet their requirements.
How long are commercial loans 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 in this case 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, freeing up money to be used on other expenses.
What kind of interest rates are common for commercial loans?
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. So if you have a low credit score, less-than-great business finances, or if the property you wish to purchase needs renovations, you’ll have to pay higher interest rates and have a higher downpayment in order to get a commercial loan.
What types of properties can I purchase or renovate with a commercial loan?
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.
What if I have other questions?
The team at Co/LAB Lending is here to help with any of your commercial loan questions. Contact a member of our team today!
