What is a commercial loan?
A commercial loan is debt provided by a bank or other lender to a business to fund operations, buy equipment or property, or cover other company expenses. Unlike equity financing (selling ownership), a commercial loan must be repaid with interest according to a schedule and often requires some form of security.
Key terms (defined)
– Collateral: an asset (real estate, equipment, accounts receivable) that a lender can seize if the borrower defaults.
– Prime rate: a common reference interest rate banks use to price loans; lenders often add a margin to this benchmark.
– Revolving credit: a credit facility (like a business credit card) that lets a borrower draw, repay, and redraw up to a preset limit.
– Term loan: a loan with a fixed principal amount and a set repayment period (non-revolving).
– Personal guarantee: an individual’s promise to be personally responsible for the business debt if the business cannot pay.
How commercial loans work (step-by-step)
1. Application and documentation: the business provides financial statements, tax returns, cash-flow projections, and a business plan to demonstrate repayment ability.
2. Underwriting: the lender evaluates creditworthiness—business credit history, profitability, collateral value, and sometimes owners’ personal credit.
3. Pricing and terms: the lender sets the interest rate (often tied to prime or another benchmark), the repayment schedule, collateral requirements, covenants (financial conditions the borrower must meet), and fees.
4. Closing and disbursement: loan paperwork is signed; funds are released.
5. Monitoring and reporting: lenders commonly require periodic financial statements, proof of insurance on financed assets, and compliance with covenants throughout the loan life.
6. Repayment or renewal: term loans amortize over a set period; some commercial loans are renewable or rolled into new facilities if agreed by the lender.
Common types of commercial loans
– Term loans: fixed principal, fixed or variable interest, set maturity.
– Lines of credit (revolving): borrow up to a limit, repay, and borrow again.
– Equipment loans: secured by the equipment being purchased.
– Commercial mortgages: loans for buying or refinancing commercial real estate.
– Bridge loans and mini-perm: short-term financing that “bridges” until longer-term funding is arranged; mini-perm loans commonly have 3–5 year terms.
– SBA-guaranteed loans: government-backed loans for small businesses (see SBA program details below).
Special considerations
– Collateral and guarantees: many lenders require assets as security and may ask owners for personal guarantees, especially for small businesses.
– Short vs. long term: many commercial loans are short-duration (e.g., 3–5 years); some lenders offer renewable facilities.
– Reporting and insurance: expect regular financial reporting and insurance requirements for large purchased assets.
– Pricing tied to benchmarks: interest often references the prime rate or another index, plus a margin reflecting borrower risk.
What lenders expect (brief checklist)
– Up-to-date financial statements (balance sheet, income statement, cash
flow statement), recent tax returns, accounts receivable aging, copies of leases and major contracts, details on collateral, schedules of existing debt, insurance certificates, business plan or loan-purpose memo, and owner personal financial statements and credit reports.
– Other common items: articles of incorporation/organization, business licenses, environmental reports (for property-heavy loans), appraisal or valuation of collateral, and any litigation disclosures.
Common underwriting metrics (definitions, formulas, and quick examples)
– Debt-Service Coverage Ratio (DSCR): measures cash-flow ability to cover debt payments.
– Formula: DSCR = Net Operating Income (NOI) / Annual Debt Service
– Example: NOI = $200,000; Annual debt service = $150,000 → DSCR = 200,000 / 150,000 = 1.33.
– Typical target: lenders often want DSCR ≥ 1.20–1.35 for commercial real estate; thresholds vary by lender and industry.
– Loan-to-Value (LTV): compares loan amount to value of collateral.
– Formula: LTV = Loan Amount / Appraised Value
– Example: $800,000 loan on $1,000,000 property → LTV = 80%.
– Debt Yield (real estate metric): NOI / Loan Amount; shows return to lender if foreclosure needed.
– Formula: Debt Yield = NOI / Loan Amount
– Example: NOI $150,000 on $1,500,000 loan → Debt Yield = 10%.
– EBITDA and Interest Coverage Ratio (ICR): used for operating-company loans.
– EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization.
– ICR = EBITDA / Interest Expense.
Loan structures and typical terms
– Amortization vs. term: Amortization is the repayment schedule (e.g., 20-year amortization). Term is the loan’s life before maturity or balloon (e.g., 5-year term with 20-year amortization produces a balloon payment at year 5).
– Fixed vs. floating rate: Fixed = interest rate constant for term; floating/indexed = rate = benchmark (e.g., prime, LIBOR successor) + margin.
– Covenants: affirmative (what borrower must do) and negative (what borrower must not do). Common covenants: maintain DSCR, restrictions on additional debt, limits on distributions.
– Prepayment: loans may include prepayment penalties (yield maintenance, step-down penalties, or lockouts).
Worked example — amortization and balloon calculation (rounded)
Assumptions: Loan = $1,000,000; Annual interest = 6% (0.5