What is a Commercial Loan?

What is a Commercial Loan?

A commercial loan is a loan that is extended to businesses by a financial institution. Commercial loans are generally used to purchase long-term assets or to help fund day-to-day operational costs.

 Expensive upfront costs and regulatory hurdles often prevent small businesses from having direct access to bond and equity markets for financing. This means that, not unlike individual consumers, smaller businesses must rely on other lending products, such as lines of credit, unsecured loans or term loans.

A commercial loan is done between a bank and a business, used to fund operating costs and capital expenditures.

Many commercial loans require collateral, such as property or equipment.

Companies generally have to provide financial statements to prove their ability to repay.

Although most commercial loans are short-term, they can be “rolled,” or renewed to extend the life of the loan.

introduction of Commercial Loan

It is unfeasible for small and mid-sized businesses to access equity and bond markets for financing due to regulatory hurdles, associated costs, and the time required to secure the funds. Therefore, small and mid-sized enterprises use debt products such as commercial loans and/or lines of credit.

Commercial loans can ultimately be used for any purposes required for the business – acquiring assets, purchasing supplies, meeting daily operational costs, paying payroll, etc. In the loan application process, the business must specify what the commercial loan will be used for.

How Commercial Loans Work

Commercial loans are used for businesses. Unlike other types of loans, commercial loans are often unsecured and non-collateralized. This means they do not require any collateral or security as a part of the agreement.

Some, though, may use inventory or accounts receivable as collateral. At the end of the life of the loan, these are converted into cash to repay it.

If you aren’t using collateral to secure your loan, your credit history will be an important part of getting approved. If you have a good credit history and you’ve paid off your debts in the past, there is a higher chance you will get approval for your loan faster than if you apply with bad credit history.

Commercial loans typically have lower interest rates than other business loans, but may have other requirements. Commercial lenders may want to know what you intend to use the money for, how you expect your business to grow over time, how much money you take in before taxes, and other details about your business.

Every commercial loan is different and has a different set of terms. The interest rate is the loan’s borrowing rate that the lender offers. It is usually based on what other rates are available in the market. It will also be affected by factors such as:

  • Interest rates offered by other lenders
  • The amount being borrowed
  • The length of time for repayment
  • Risk factors associated with borrower
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Commercial loans can also be bundled with other financial products to provide the borrower with more options. These might include personal lines of credit, receivables factoring, and asset-based lending.

Process for Securing a Commercial Loan

Depending on the lender, the process to secure a commercial loan may be different. The general process for securing such a loan is as follows:

1. Pre-approval (Qualifying process)

The lender (bank) will begin a pre-approval process for the business by evaluating the financial history and income of the business. In addition, the lender will investigate the existing debt of the business and the purpose of the loan.

Through a pre-qualifying process, the lender can gain a rough idea of how much the business would be able to borrow and the relative riskiness of the borrower.

2. Loan application

After the pre-qualifying process, the business must complete and submit a loan application. In the application, financial statements or similar documents dating back at least three years are generally required. This is to help ensure that the business can repay the loan.

3. Review of the loan application package

Once the application is submitted, a loan officer will review these due diligence documents. They will investigate things such as credit history, available collateral of the business, the current and projected income of the business, etc. A big part of the diligence process is the financial analysis.

4. Loan underwriter/Loan committee

If the loan request is deemed appropriate by the loan officer, a complete and formal credit application is submitted to a credit adjudicator or loan committee. The adjudicator reviews all relevant information and decides whether to approve or decline the loan. The process can take up to a week, and the business may be required to provide additional documentation during the review.

5. Term sheet

If approved, the processor will present the company with a term sheet. A term sheet is a formal document that outlines the parties involved, amount of financing, available collateral, fees, use of the loan, and the interest rate on the loan. After reviewing the term sheet and signing a letter of intent, payment may be required for third-party reports, e.g., appraisal reports.

6. Loan package and closing documents

Upon completing third-party reports, the complete loan application package is resubmitted to the loan underwriter for final approval. If approved, the business is required to sign finalized loan documents. Generally, businesses employ a closing agent (e.g., an authorized representative, an attorney, etc.) who handles all closing documents and completes any remaining paperwork.

Types of Commercial Loans

Commercial loans can be broken down into two main categories. Short-term commercial loans are typically given out for periods of less than 12 months. Long-term commercial loans are typically given out for more extended periods.

Within these categories are different types of commercial loans. Your business’s needs will determine the right loan for your financial situation.

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Working Capital Loans

A working capital loan is a type of asset-based lending. This means that these loans are usually unsecured. They are often offered by banks and other financial institutions to small and medium-sized businesses.

Working capital loans are used to finance a business’s short-term capital needs for daily expenses. They are often used seasonally for things such as buying inventory, paying extra staff, purchasing equipment, or other operational costs. They have two main features:

  • They are meant to be repaid in less than one year.
  • They should be used for working capital purposes only.

At the end of the loan’s term, a business will usually convert inventory or accounts receivable to cash in order to pay back the loan.

Real Estate Loans

Real estate loans are used to purchase and invest in property. They can be used for both residential or commercial properties.

Real estate loans can either be:

  • Mortgage loans, which are secured by the property being purchased
  • Non-mortgage loans, which are unsecured and do not require the borrower to use the property they are purchasing as collateral

Real estate loans can be used for purchasing things such as residential properties or cooperatives, undeveloped land, or forests. They can also include construction-project loans. In some states, oil and mineral rights are considered real property and can be bought with real estate loans.

Accounts Receivable Financing

For accounts receivable financing, a business uses its accounts receivable as collateral for borrowing working capital. This type of financing is best for businesses that have high volumes of invoices and can’t wait for them to be paid before they can use the funds.

There are two methods for using this method of borrowing:

Blanket assignment: The business keeps the lender up-to-date on the amount of unpaid receivables. Payments are made to the business, which then makes payments to the lender.

Ledgering the accounts: The lender maintains control of the accounts by requiring that customers make payments directly to them.

Multipurpose Commercial Loans

This kind of loan is not designed for one specific purpose. Government and private lenders offer multipurpose loans to provide businesses with the capital they need to purchase, make repairs, or invest.

SBA 504 Loans

The Small Business Administration (SBA) is a federal government agency that helps small businesses and entrepreneurs grow and succeed. The SBA offers a variety of lending programs to help you meet your financing needs. Its loans range from $500 to $5.5 million.5 Businesses applying for SBA loans must meet specific size standards.

The SBA 504 loan program is designed to help small business owners develop their business plans to become successful enough to repay the loan eventually. It also is the only direct lending program that offers long-term, fixed-rate financing for small businesses with minimal collateral.

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SBA loans are for up to $5 million. With this type of loan, you make monthly payments to cover both the interest and principal over a period of up to 25 years or until you no longer own or operate your business.

This kind of loan is ideal for purchasing commercial real estate.

SBA 7(a) Loans

The 7(a) Loan Program is for a small business with less than $35 million in revenue. The applicant uses their credit history when applying for a loan from one of many participating lenders to start or expand a business.

SBA Microloans

Microloans are available for businesses requiring $50,000 or less to help them start or expand. These are available through local nonprofit organizations that partner with the SBA.

Keep in mind that in order to qualify for an SBA loan, a business must meet specific requirements, including no delinquent debts or unpaid taxes, not being a not part of a conglomerate or larger organization, and having no pending legal disputes with the government.

Advantages of a Commercial Loan

1. Access to capital

A commercial loan provides additional cash for a business. The cash may be used to purchase new equipment, satisfy payroll expenses, etc.

2. Easier application process

Although the application process for a commercial loan may seem daunting, it is easier than raising money in the equity or debt markets. There are regulatory hurdles and significant costs and time required to raise money through equity and/or bond markets.

3. Retaining ownership

A commercial loan does not dilute the business owner’s equity. For example, a business may issue equity to raise money. In doing so, the owner would be diluting their own equity in the business. As such, a commercial loan allows an owner to raise money without diluting their stake in the business.

Disadvantages of a Commercial Loan

1. Paperwork and application process

A commercial loan requires a significant amount of paperwork and involves a tedious application process. For example, a business may be required to submit an outline of its business plan and give a presentation outlining its business goals and objectives.

2. Inflexibility in the use of funds

When applying for a commercial loan, the business must specify what the money will be used for and how it will pay back the loan. This results in inflexibility of the funds, as the business is required to commit to its original plan(s).

3. Interest costs

A commercial loan comes with a stated interest rate, which may be floating or fixed. As such, the business is required to make monthly payments on the money it borrows.

Want to learn more about commercial loans and find out what it takes to become a world-class Commercial Loan Broker or Commercial Loan Officer? Use the form below to learn more about CFI’s Commercial Banking & Credit Analyst certification.