What is it and How Commercial Lending Works

Small business loans, specifically commercial loans, were designed to provide access to borrowed capital for businesses that need a working capital boost, whether it be to address everyday costs or to begin the next stage in their business journey. 

If you’re considering taking out a loan, educate yourself on the various types of lending products, as well as their requirements.

What is a Commercial Loan?

A commercial loan is a lending agreement based on debt. It’s typically made between a lender (usually a bank or other financial institution) and a business. Commercial loans help business owners  cover operating costs and other big expenses they might not be able to afford otherwise.

How Do Commercial Loans Work?

There are many types of business financing options that might fall under the commercial lending umbrella. Most will have set terms, a fixed repayment plan, and rates based on creditworthiness, however, there are different types of commercial loans as well as commercial lenders. For example, some commercial lenders will require the borrower to put up certain assets as collateral, while other commercial banks will require a down payment, while still other financial institutions might not require either.

Advantages of a Commercial Loan

Getting a commercial loan can give small business owners a number of benefits and advantages, especially if they’re starting a new business. 

One of their most important benefits is that they generally have lower interest rates than other types of loans. This means business owners can get the funds they need while keeping costs low, allowing them to increase their profits more quickly while they pay the loan off. 

Commercial loans also tend to have longer repayment terms, giving business owners more time to pay with smaller regular payments.  And they can provide larger sums of money than other types of loans, enabling greater options on spending.

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 secured loans, so defaulting could also mean losing any collateral you’ve provided. 

What are Ideal Business Uses for a Commercial Loan?

  • Expanding the business into new markets
  • Purchasing new equipment
  • Moving into new property
  • Paying off debts
  • Helping with cash flow and working capital
  • Acquiring another business

Commercial Lenders

Depending on the lender you work with, everything from the application process to the periodic payment schedule can vary. The same is true for eligibility requirements—some can be very strict while others work very well with borrowers that have less-than-perfect business or personal credit profiles.

A commercial lender could be a traditional lender like a bank or credit union, an online lender, or even an independent investor, depending on the type of financing you are looking for. The SBA also guarantees commercial loans.

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 purchasing commercial property, hiring employees, buying equipment, and buoying up cash flow.

SBA Loans

Small Business Administration (SBA) loans are backed by the SBA and approved and originated by lenders. 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 by Certified Development Companies (CDCs), which are non-profit companies that promote economic growth within a specific area.

Approved applicants for these real estate and development loans can expect funding amounts up to $5-5.5 million dollars with terms typically ranging from 10 to 20 years.  

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.

Rates are based on an acceptable spread of the current prime rate, interbank rate, or SBA Peg rate, the loan amount, loan term, and your credit profile. Currently, borrowers can expect rates between 5.5% and 9.75%. However, the SBA limits low rates as follows (the prime rate currently being 3.25%)::

SBA Loan Rates

Loan Amount Loans less than 7 years Loans 7 years or longer
$0 – $25,000 7.5% 8%
$25,001 – $50,000 6.5% 7%
Over $50,000 5.5% 6%

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 traditional lenders like banks or credit unions, online lenders, and even some private lenders. As such, rates, terms, and amounts can vary. However, borrowers can typically access between $5,000 and $250,000 with rates between 6% and 20%.

There are, however, lenders that have rates well above the 20% mark.

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 in some cases, even help you earn rewards.

Credit cards have few usage exceptions—you won’t have to limit spending to materials, labor, etc. (depending on your credit limit)—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.

NOTE: Many business credit cards have tightened their credit criteria resulting from the economic challenges caused by the coronavirus crisis, but if you have a reasonably strong personal credit score and business credit profile, there are still options available to you and your business.

When possible, choose a credit card that offers low interest—one that offers a 0% introductory APR offer is ideal. Further, you may also want to consider credit cards that offer rewards programs, 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 recessionary 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.

Real Estate-Specific Commercial 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 Fixed Interest Rate “Mortgage” 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, with rates between 3% and 12% for approved borrowers. 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% deposit based on the total amount of the loan.  

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 it in case of default—and then sell it to recoup the loan.

These loans are notoriously more expensive than other options, with a variable rate ranging from 7% to 15%, on average. 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.

Mortgage or 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.

Generally, interest rates range from 4% to 12% but vary based on prime rates, type of lender, amount of loan, and the borrower’s creditworthiness. In addition to interest, borrowers who qualify can also expect a variety of fees (like project review or fund control fees) as well as a 10% to 30% deposit requirement, which is based on the total cost of the project.

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 willl 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. If you qualify, you can typically expect terms between two and 30 years, with rates between 4% and 11%.

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 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 rates on two primary factors: your business finances and your personal finances. 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 will look at your business credit profile, 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 will 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. You can access both your personal and business credit scores at Nav for free to get an idea of what you may qualify for.

Like personal loans, which take into consideration an applicant’s debt-to-income ratio, a commercial lender typically looks at your company’s “debt service coverage ratio” when going through the credit approval process. This 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, tax returns, business checking account statements, and more.

How Do You Qualify for a Commercial Loan?

Most of the same criteria that are used to determine the rate you are eligible for are used to determine eligibility for a commercial loan. Some lenders want you to have been in business for a certain number of years, and some have a threshold credit score. Some may require collateral.

What Deposit is Required for a Commercial Mortgage?

Some lenders specializing in commercial real estate loans may require a 20-30% down payment on the loan.

What is the Minimum Down Payment for a Commercial Loan?

Some loans require down payments, and others do not. 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.

This article was originally written on April 30, 2022 and updated on May 2, 2022.

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