What Are Commercial Loans?
November 15, 2022
Put simply, commercial loans are a method for business owners to meet business needs by receiving up-front money from a financial institution in exchange for repayment with interest. The financial institution, typically a bank, credit union, or online financer, is known as the lender, while the business receiving the money is known as the borrower.
The borrower will apply for a loan and the lender evaluates the borrower based on several factors to determine their creditworthiness. Those factors can include business credit scores, age of the business, the business’s industry, and more. The lender may also charge origination fees along with several other upfront costs.
The lender can also require the borrower to put up collateral, or valuable assets that the lender can take possession of in the case of default. If the borrower puts up collateral, that loan is called a secured loan. Alternatively, if the lender requires no collateral, that loan is said to be unsecured.
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Why Businesses Get Commercial Loans
There are many different forms of commercial loans and there are also many different reasons to acquire them.
Working capital. Every company needs cash on hand to deal with some of the expenses that come with the day-to-day operations of a small business. Many commercial loans work as working capital boosters in order to make sure that small business owners can pay employees, improve real estate, or otherwise just have flexibility.
Refinancing existing debt. Many business loans are used to refinance debt in order to reduce interest rates, lower monthly payments, and generally build a healthier loan program.
Buying equipment. Chances are, your company, whether you own a restaurant or an appliance store, needs equipment to function. Machinery breaks and technologies grow obsolete. You may need to upgrade, replace, or repair existing equipment to keep up with customer demand.
Real estate. You may find that you’re in need of some commercial property in order to keep moving forward. It’s rare to find a small business that wouldn’t need some sort of financing in order to move into a new space, and commercial real estate loans are a popular way to do so.
Types of Commercial Financing
Even beyond these purposes, there is any number of reasons to seek small business financing. And with the variety of purposes comes a variety of types of loans available to serve those purposes.
Each type of financing listed here comes with pros and cons for borrowers and lenders alike. Borrowers are looking for the largest possible loan with low interest and maximum flexibility. Lenders are looking to make money with minimal risk to their own bottom line. Keep that in mind as you read on.
Term loans are a blanket term for many of the types of loans offered by commercial lenders. In all term loans, the borrower completes an application process and the lender determines an appropriate loan amount and interest rate. The borrower then makes payments each month until the loan is repaid in full, with interest.
Short-term loans are term loans with a repayment term typically shorter than 18 months. Because of the brief repayment periods, short-term loans are typically for smaller amounts than other loans and come with higher interest rates.
On the other hand, if the repayment terms for the loan take several years they can be classified as long-term loans. That extended repayment term means that long-term loans are often substantial and can be used for major purchases, including real estate.
Because they can be so large, long-term loans sometimes involve a difficult approval process for borrowers. Lenders are effectively wagering six or even seven figures that your business will be able to repay the loan in full, so they’re very diligent about the companies to whom they’re lending money.
The U.S. Small Business Administration (SBA) guarantees some loans through third-party financial institutions. These SBA loans are sometimes the least expensive option in commercial lending, as the government’s guarantee means that the banks and credit unions underwriting the loans face limited risk. If you’re looking to spend the absolute minimum on business financing, SBA loan rates are likely to be the lowest available. There are two main forms of SBA loans available for small business owners.
SBA 7(a) loans are the most common form of SBA loans. These are term loans of up to $5 million available for just about any purpose. Interest rates are dependent on the current U.S. prime rate, or the interest rate that the government charges when lending to its most creditworthy customers.
The SBA Microloan program involves funding loans of less than $50,000 through local non-profit finance organizations. These microloans are for about $13,000 on average and have repayment terms of six years at maximum. If you’re in need of a small financing option with minimal interest, SBA microloans can be a great option.
Unlike the loans discussed previously, equipment loans have a highly specific purpose. As their name implies, equipment loans are used for equipment. Leasing, purchasing, renting, upgrading, renovating, and replacing equipment are all eligible for an equipment loan. The borrower makes a down payment and then receives the rest of the cost of the equipment as a loan.
In exchange for lower interest rates, the lender holds the new equipment as collateral. So if the borrower is for any reason unable to repay the loan, the lender can take possession of the equipment and sell it, protecting them from undue financial risk. If you’re looking for business financing specifically for a piece of equipment for your company, an equipment loan could be a low-cost way of doing so.
Lines of Credit
Instead of receiving their lump sum upfront, some businesses opt to go for a business line of credit. A business line of credit offers a credit limit, and the business owner can withdraw cash up to that limit. That cash can be used for a variety of purposes, just like a term loan.
The difference is, businesses make payments (and pay interest) only on the money borrowed under the credit limit. Some businesses choose to use that line of credit as a sort of rainy day option. If a piece of equipment breaks, it can take days or weeks to receive funding through an equipment loan. On the other hand, a line of credit is available for use immediately. And as you pay down the money you’ve borrowed, you can re-borrow back up to the limit. This is known as revolving credit.
Business Credit Cards
Business credit cards work just like personal credit cards. Cardholders are able to use the card to spend money up to a particular credit limit and pay interest only on what is borrowed. The main difference is that business credit cards are typically used to make purchases directly instead of being transferred to cash like a line of credit. And much like personal credit cards, business credit cards also allow for cashback and other rewards for frequent use.
Non-Loan Option: Merchant Cash Advances
A merchant cash advance is not a loan but is another helpful form of commercial lending that can help small businesses afford operational costs. In a merchant cash advance, or MCA, the cash advance provider purchases a portion of the company’s future debit and credit card transactions. The borrower then makes daily or weekly payments based upon the volume of transactions on that particular day. When sales are higher, payments are higher. When sales are slower, payments are lower.
Cash advances are good options for companies with poor credit, and can sometimes hit the borrower’s bank account in a single business day after submitting the application. The downside is that the daily payment nature can be a bit of a squeeze on cash flow, and the effective APR on an MCA can be considerably higher than other forms of funding.
Documents Needed To Get A Commercial Loan
No matter which type of loan you decide to pursue, there are a number of documents you’ll need to prepare in order to make sure the application process goes smoothly.
Loan application. The first document you’ll want to have in hand is the financial institution’s application for the loan.
Resume. You’ll want to prove to the financial institution that you’re a safe bet and that you’re likely to repay the loan. A resume will show the lender the reasons you’re the right person to loan to and that you have the expertise to make your company work.
Tax documents. Many loans require a certain amount of annual revenue to claim eligibility for that loan. Your business tax returns will show your revenue and prove that you’re eligible for the loan in question.
Business Plan. What do you project your company to look like years down the line? Many lenders want to know what you’ve got planned, and a well-written business plan shows them how their loan will help your company.
Financial Statements. Your financial statements include balance sheets, cash flow reports, bank statements, and more. Some lenders will require these documents on a personal level in addition to a company level.
Credit Report. Obviously, every lender will want to see your company’s history when it comes to repaying its debts. Your credit report will show how much debt you’re currently carrying, your payment history, and more. Some loan providers, like online lenders, may be more flexible about credit scores, while traditional banks tend to be a bit more strict.
Legal Documents. Your licensing, your articles of incorporation (if applicable), leases, and any other paperwork that shows your company is operating legally.
Commercial Loans are an Important Part of Running a Small Business
No matter why you’re receiving a loan, where you’re getting it, and how you’re spending it, nearly every single small business uses debt financing to handle operations. Examine your business plan, consider your options, and ensure that your paperwork is all in order. The right loan from the right lender can create a healthy financial ecosystem for long-term growth.