Commercial Loans
The term "Commercial loans" is usually a generic name for various types of loans used for business purposes. Commercial loans are debt instruments issued by a bank or other financial institution that require the borrower to pay back principle loan amounts, interest and any applicable fees over a specified period of time.
Types of Loans at a Glance
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Commercial Loans (long-term)
Usually larger amounts used for purchase of real estate or major capital expenses, paid back over a long period of time from 5- 10 years. Loan amounts are generally above $1 million.
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Traditional Term Loans (medium term)
These are the most common types of loans for small businesses. They can be general purpose and paid back from 1- 5 years. Loan Amounts vary from $25,000 to $5 million.
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Short-term Loans (3-18 months)
These are usually cash-advance type loans designed to cover short-term expenses or provide additional capital during seasonal revenue lulls. Loan amounts range from as low as $5,000 to $250,000.
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SBA Loans
SBA Loans offer a long-term, low interest rate loan program that is partially guaranteed by the Small Business Administration and issued through participating SBA lenders, most commonly a traditional bank. SBA loans are almost always in the form of traditional term loans in that they are issued as lump-sum disbursements to the borrower.
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Equipment loans
Equipment loans are a type of business financing designed specifically for the acquisition of new business equipment using the new equipment as collateral.
In practice, many large banks in the U.S. commonly associate a commercial loan with the purchase, improvement or refinance of commercial real estate.
While the expression commercial loans are used generically, it is important for business owners to understand that there are many choices when it comes to business financing. Not only are business loans created differently, there are now many more sources to acquire a commercial loan. Loans are created differently to service the varied needs of a business. For example, short-term loans versus long-term loans, secured versus unsecured, and line of credit versus lump-sum borrowing are differing loan programs. In this section we will review the most popular options for commercial loans, how they work and how to get them.
Typical Uses for a Commercial Loan
Commercial loans are typically used to fund large capital purchases or to finance operational costs usually associated with business expansion or acquisitions. Commercial financing or commercial loans can also refer specifically to a commercial real estate loan. However, commercial financing can be used in a variety of ways and are increasingly classified as general purpose loans.
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Operational expenses
Operational expenses (also known as OpEx) are associated with ongoing costs a company pays to operate its core business activities. An example of operational expenses may include costs to meet higher payroll demands, cover extraordinary seasonal expenses or to purchase goods used in the manufacturing process.
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Capital expenditures
Capital expenditures (also known as CapEx) are funds used by companies to acquire, upgrade and maintain physical assets. Common capital expenditures may include purchase of new equipment, upgrading business technology, facilities and inventory, and of course, real estate. That said, commercial loans are generally characterized by larger loan amounts and longer durations such as those associated with real estate purchases (commercial mortgages) and large capital expenditures, such as heavy machinery or capital items that have a longer useful life horizon.
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Who Qualifies for a Commercial Loan?
Commercial loans (in the traditional sense) are usually given by medium to large banks and financial institutions. The borrower profile tends to be a business owner with a strong credit history (680 personal credit score or better), at least $250,000 in annual revenues and those companies that have been in business for several years. In addition, these types of loans almost always require some degree of collateral to be pledged against the loan in case of default.
For example, Bank of America posts its minimum requirements for a commercial loan as having a minimum of 2 years in business under existing ownership and a minimum of $250,000 in annual revenue.
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Costs of Commercial Loans
Because of the high degree of qualification requirements to acquire commercial financing, as well as the larger loan amounts, qualified businesses will generally be given more favorable borrowing terms. This includes lower interest rates as measured by Annual Percentage Rate (APR), longer pay-back periods (up to 30 years), as well as lower fees associated with the financing amount as a percentage of the loan proceeds. This is a general rule of thumb.
What is the Most Common Source of Commercial Financing?
Depending on the size of the loan amount requested, banks are the leading source of commercial loans for business. Most commercial loans are given to businesses by local banks. This is traditionally the first place where the majority of business owners go to acquire business funding. Having an established business banking relationship with a local financial institution may increase your chance of getting a loan if you have establish a track record of stable business activity over a period of years. If the bank and the loan officer know you and your business, they are more inclined to give your loan request a higher level of consideration.
However, for larger loan amounts ($5 million and above), your local bank may not be the most appropriate place to look for a commercial loan. Check with your banker to see what loans sizes they will service before applying.
Small Business Administration
Small Business Administration (SBA loans) guaranteed Loans (which are offered through banks) are among the most attractive loan programs for getting commercial financing. SBA guaranteed loans are well suited for capital purchases and therefore all also very popular for commercial loan borrowers.
Specifically, the SBA 504 loan is highly suitable for commercial real estate loans of $350,000 and above. The SBA 7A and SBA Express loan programs will generally offer lower down payments and longer terms for repayment.
In general, SBA loans offer lower interest rates and lower costs overall for borrowing. However, SBA loans may involve considerably more paperwork and have tougher qualification requirements than other loan applications. SBA loans are known as loans of "last resort." With almost every SBA loan program the SBA requires a business owner to have exhausted all other financing options before they can apply for an SBA guaranteed loan.
General Qualifications for an SBA Loan include:
- You own and operate a for-profit business
- Your business is legally organized as a sole proprietorship, corporation, partnership or LLC
- Your business does not generally qualify for conventional credit
SBA CDC 504 Loans from $350,000
| Terms: | |
|---|---|
| Purchase equipment | 7-10 years on equipment |
| Purchase commercial real estate | 10-20 years on real estate |
| Fund construction or renovation | Up to 2-year construction period |
| Loans from $350,000 | |
SBA 7(a) Loans from $350,000-$3.5 million
| Terms: | |
|---|---|
| Purchase equipment or inventory | Up to 7 years for working capital |
| Purchase or expand a business | Up to 10 years for purchases |
| Get working capital | Up to 25 years for real estate |
| Refinance debt | |
Understanding the Importance of
Speaking the Language of Business Loans
The business financing marketplace has become highly specialized. It's not uncommon at larger banks to have a person, or entire department dedicated to a particular type of loan product. For example, Capital One Bank has over 12 separate loan departments or teams dedicated to specific types of commercial real estate lending activities classified by industry type. It's easy to get caught-up in complicated finance jargon, so knowing the right loan for your needs and qualifications is important.
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What is the Purpose of the Loan?
A professional loan officer will likely ask you the purpose of your loan. Don't be alarmed, this is the first logical question you should be asked. The purpose of the question is to determine what class of loan is best suited to your needs. In fact, if you are not asked that question, you should bring it up early in the conversation and ask what type of loan products are offered for that purpose. Knowing this will be helpful when comparing loan programs among different lenders.
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Applying for a Commercial Loan
After reviewing the available options for commercial financing and choosing the right option to fit your business needs, you may wish to carefully plan your application strategy. Be prepared and spend some time assessing the requirements and you company's position.
After exploring your options make a determination which loan program will give you the highest probability of being approved. As discussed, each commercial loan program has different qualification requirements. However, there are some basic qualifying criteria that are consistent among lenders.
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Annual Revenue
This is the most important indicator for a lender. Your annual revenue will tell the lender if you are able to repay the loan amount you have applied for.
As a rule of thumb, lenders will set their lending amounts to a small percentage of your average revenue. Depending on other criteria used in the decision-making process, the percentage could range from 12% to 18% of annual revenue. Using sophisticated models based on years of experience and literally millions of loans, lenders have devised loan formulas to take into account unforeseen expenses and revenue fluctuations.
That means a business owner with $1 Million in annual revenue can expect to receive a loan from $120,000 to $180,000. This is just an approximation, but reflects actual averages.
Lenders will seek to verify your revenues in several ways. You will be asked to provide the company profit and loss statement as well as your business and personal tax statements. The tax returns provide the most reliable picture of revenue activity and therefore are almost always required by a lender.
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Bank Statements and Average Balances
Your bank statements will show a lender how cash flows through your organization. It's like taking the pulse of your business. Lenders want to see if you are managing your corporate finances properly. For example, repeated overdrafts in your business banking account may suggest poor fiscal management of problems with cash flow.
Be sure to maintain at least one year of stable, if not increasing bank balances. Lenders want to see that you have sufficient capital to sustain business-cycle fluctuations and that as a business owner you are prepared for these unforeseen events. It shows prudent business stewardship.
The lender also expects that businesses should have filed at least 2 yrs of tax returns showing sufficient profits to cover the principal and interest payments and still have some surplus. This is known as Debt Service Coverage Ratio ( DSCR) and typically banks are looking for DSCR of anywhere between 1.1 to 1.5 over a 2 to 3 yr period.
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Time In Business
Many lenders will simply wish to know that your business is viable. The most recognized statistic among business owners is that over 80% of all businesses fail before their first two years in business. It's no surprise that most lenders will require at least two years in business to qualify for a commercial loan.
Time in business is especially important when applying for long-term financing. After all, if you have been in business for the minimum of only 2 years and you are applying for a loan that will be paid-off over 30 years, the lender is taking a high risk. Statistically-speaking, the chances a company will survive for 30 years after only 2 years in operation is unlikely. Beyond 2 years, your company becomes a better credit risk.
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Credit Score
Your personal and company credit rating will play a large part in the loan determination process. Your credit score shows your history of handling credit and therefore is an indicator or your trustworthiness.
Put simply, lenders assume that your past credit history is a good indication of how you will handle your finances going forward. Lenders will be looking for "red flag" items such as delinquencies, write-offs, bankruptcies, tax liens and similar such derogatory items.
In addition, your credit score will give the lender a profile on your use of credit and whether you are applying for credit elsewhere (inquiries). Unfortunately, credit inquiries (places you have applied for credit recently) reduce your credit score, even if you have not borrowed any money from that source.
Therefore, applying for credit before you do some basic preparation is not a wise way to determine your eligibility. Following some of the guidelines in this article may help improve your chances of finding the right loan and getting that loan request approved.