The Definitive Guide to Commercial Loans for Small Businesses
June 8, 2020
June 8, 2020
Understanding how a commercial loan is different from a consumer loan is a fundamental necessity for any small business owner.
A commercial loan is used to finance equipment, machinery or inventory. Banks generally mandate that the commercial borrower submits monthly and annual financial statements, and require the borrower to maintain insurance cover on the financed item.
With a commercial loan for a small business, the amount of money sought is usually more than it would be for a consumer loan. A business’ need to cover the costs of projects or maintenance will entail greater funding than an item that an individual consumer is seeking to finance.
Commercial loans don’t come with as much protection for the borrower as consumer loans. A commercial loan may be collateralized by inventory or equipment. A commercial loan may also require that the owner of the company put personal assets up as collateral. The law assumes that businesses have a better comprehension of the terms and requirements of the financial activities that they undertake than an individual consumer might.
Commercial loans are sometimes conflated with business loans. A commercial loan is a more structured instrument, whereas a business loan is a more general description of loans that are not individual consumer loans. Commercial loans, which fall under the umbrella of a business loan, are often what is given to larger mid-market companies.
When a lender provides pre-approved funding with a maximum credit limit, that is known as a business line of credit. If the borrower is approved for this line of credit, funds can be accessed whenever they are needed until the established credit limit has been reached.
Because the borrower is only paying interest on the amount that he or she withdraws, a business line of credit can be advantageous for business owners who are uncertain of the amount of funding they will actually require, or when they might need it.
The drawback to a business line of credit is that the loan will be at a rate that might be considerably higher than other types of loans. How costly that actually would be is heavily dependent on the amount of funds the entrepreneur ends up using.
If a business owner needs to establish a favorable credit history, a business line of credit could help him or her do that.
A seasonal business might favor a line of credit because its cash flow tends to be less consistent from month to month. Manufacturers, service companies and contractors are other common candidates for lines of credit, which help a business owner meet his working capital needs or bonding requirements without enduring a new application process each time with the help of a revolving line of credit.
If cash flow impedes the purchase of vehicles or machinery, small businesses can turn to equipment loans to finance the heavy-duty parts they need to make a go of things. A number of providers ranging from traditional banks to alternative lenders are available to lend money for equipment. The rates for an equipment loan could be anywhere from 6 percent to 9 percent.
Businesses must come up with a down payment of between 10 and 30 percent in an equipment loan agreement. The lender will finance the remainder.
When a business’ equipment starts to wear out or become outmoded, and the company still needs that type of equipment to operate at maximum efficiency and productivity, then the business needs new equipment and a way to pay for it.
A small business operating on a limited budget may see financing equipment as an attractive option to preserve its cash on hand by dispersing the funding of needed equipment over several months or years in predictable, equal payments.
Assets whose value is unlikely to depreciate much are suitable subjects for equipment financing.
For many small businesses, equipment can be financed up to 100 percent of its value. Most lenders will set the term of the loan equal to the equipment’s expected useful life. Most computers and software have an expected useful life of between three and five years, according to actuarial website AssetWorks.
A loan that is secured for the purpose of buying equipment, an equipment financing loan is secured by the equipment itself. A business that can’t afford to pay off the loan would end up surrendering the equipment as collateral.
The U.S. Small Business Administration (SBA) offers commercial financing backed by the SBA through its SBA 7(a) loan program. The most common type of SBA loans, an SBA 7(a) loan assists businesses in the purchase or refinance of owner-occupied commercial properties up to $5 million. This loan also gives the business owner a chance to borrow funds for working capital.
These loans are suited to assist businesses that are unable to secure credit anywhere else. With an SBA (7a) loan, the borrower can purchase land or buildings, build on new property or renovate existing property as long as the real estate will be occupied by the owner. Through an SBA (7a) loan, an entrepreneur can borrow up to $5 million through an SBA-affiliated lender. The maximum allowed interest rates for the program are based on the Wall Street Journal Prime Rate plus a margin of a few percentage points. Interest rates can be fixed, variable or a combination of the two. Loan terms for 7(a) loans that are used for commercial real estate may be as long as 25 years for repayment. Each monthly payment would be the same until the loan is fully repaid.
Backed by the U.S. Small Business Administration, this type of financing can assist in the purchase or refinance of an owner-occupied commercial property. These 504 loans are actually a hybrid form of financing: One loan coming from a Certified Development Company (CDC) for up to 40 percent of the loan amount, and one loan from a bank for half the loan amount or greater. Low down payment requirements make CDC/SBA 504 loans ideal for growing companies that might not have more than 10 percent to use as a down payment.
A CDC/504 loan is for either 10 years or 20 years. Borrowers get a fixed rate rather than the prime lending rate. Applicants will be required to show the lender a business plan, exhibit proof that they’re capable of managing a business and present projected cash flow data–all to assure the lender that the loan is likely to be repaid without complications.
A short-term form of funding, a commercial bridge loan can close a gap that exists between the capital a business owner requires right now and a longer-term answer to financing. A bridge loan for a business can help a company owner get his or hands on cash in an expedient manner when there is a present shortfall in cash while expenses remain particularly pressing.
A small business might consider a bridge loan to keep the company solvent and able to pay its bills during a time when cash on hand is scarce but invoices that are outstanding are on their way to being paid off. If a business is in the market for new real estate, but lacks the time required to go through the process of securing a mortgage, the company owner might opt to seek a bridge loan.
A bridge loan intended to cover expansion plans answers the need for capital, so that a growing company can hire more employees, search for more spacious accommodations or renovate and expand present space, and buy the time needed to expand.
Commercial financing can also be expedited through a hard money loan from either a company or an individual. These loans can be achieved more expediently than securing credit from a bank, which requires jumping through more hoops to comply with regulations. The time frame difference between a hard money loan and a traditional loan from a bank could be the difference between a week or two and a month or two.
Hard money loans are comparable to bridge loans, with one big difference: the down payment and interest rate on a hard money loan usually will be higher than a bridge loan, because of the higher risk of default. But it’s a possible solution to the need for fast capital.
Another way to facilitate access to money needed to finance one’s business expenses is a merchant cash advance. In this instance, a company grants the borrower access to cash. The borrower is then required to pay a portion of her sales made with credit and debit cards, as well as an additional fee.
A merchant cash advance does not require collateral or a minimum credit score. However, merchant cash advances to immigrant business owners involve higher costs than most other forms of borrowing.
Funds provided by a bank to a small business owner for a specific purpose, to be paid after a short amount of time, are advances. Those are to be distinguished from loans, which are an amount of money that a business borrows from a bank or other lender that must be repaid after a specific pre-arranged period with an interest rate added to the cost of repayment. The source of a cash advance automatically deducts a percentage of the borrowerâ€™s credit or debit card sales until the amount that had been agreed upon has been repaid in full. Fees for cash advances are charged as a percentage of the total cash advance amount. If a business owner withdraws $1,000 on a credit card with a cash advance fee of 3 percent, he would pay a fee of $30 which would add to the balance on the card and increase the businessâ€™ interest charges.
A legal document that transfers responsibility for collecting payment for goods and services shipped from a business to a buyerâ€™s bank, a letter of credit is a loan frequently employed by import/export businesses, contractors and travel agencies to serve as an assurance of payment.
If a buyer has a letter of credit covering a shipment, the buyerâ€™s bank has promised that the small business will receive payment for that shipment, even if the foreign buyer does not pay.
Documentary letters of credit often are for six months or less, although a stand-by letter of credit may be renewed annually. A letter of credit provides a guarantee that a vendor will get paid. An application to a bank or credit union for a letter of credit employs either cash, real estate or other business assets as collateral. After approval, the lender will compose a letter of credit with a specific dollar amount guaranteed to a specific vendor. Although a letter of credit is useful in export businesses, it carries with it high expenses for foreign buyers.
Once an installment loan–a type of loan that often is called a term loan–has been approved, a small business secures all of its capital up front, and then begins paying the loan off at regularly scheduled intervals, often once a month. Whether it is for the purposes of consolidating debt or for business expansion, installment loans come with a certain level of predictability. The amount of the monthly payments is fixed.
How much the borrower owes in the installments is calculated by adding the principal to the interest and then adding fees or further charges that have been applied to the loan. When a company gets approval for an installment loan, it is only permitted to use the funds from the loan for the previously agreed-upon purpose.
When money is required for a short-term investment, or for a quick infusion of cash without the burden of exorbitant interest rates, a short-term loan might be just the right kind of financing for a small business owner. Short-term loans usually range from three to 12 months, and they are more likely to require collateral than loans of longer terms, but for a borrower who is relatively certain that he or she will be able to pay back the loan on time, a short-term loan can save businesses money.
Although the credit requirements are not as strict for short-term loans as they are for regular term loans, the frequent payment schedule may be burdensome for someone in a new business without a lot of cash flow at that moment. With fewer requirements than longer-term loans, short-term loans may be easier to get approval than some other types of loans.
Whether a small business owner qualifies for any type of commercial loan is going to depend heavily on how credit worthy that entrepreneur is. The loan applicant is required to present documentation showing the lender that the business is generating cash flow that is consistent. The bank or other type of lender will be looking for balance sheets to gain assurance that loan will be repaid in full on time.
If a business gets approval, the interest rate it will pay will be in line with the prime lending rate at the time the loan is issued. Before the loan application, banks usually ask for monthly financial statements from the borrower during the entire length of the loan and often require the company to take out insurance on any larger items purchased with funds from the loan.
The better a business owner’s credit score, the more likely that person will be to get approved for commercial financing. The three major credit bureaus â€” Equifax, Experian and TransUnion â€” will fulfill requests for an individual’s credit score once a year. Other factors that a lender will consider before deciding on approval include how long the borrower has been in business, how much revenue the company generates and whether the borrower’s cash flow will enable him to meet the repayment terms. Since as many as one-fifth of new businesses donâ€™t make it past Year One, lenders require a company to be at least six months to two years old and will also look at how long the business has had a bank account when mulling approval.
How much debt a small business has when applying for a commercial loan will also impact the likelihood of getting approved. Most lenders require a debt-to-income ratio of 50 percent or lower. Lenders are less likely to sign off on a loan to borrowers who are already trying to pay off other loans. One solution for strengthening one’s credit score is to maintain a small balance on credit cards and lines of credit. The larger the balance is on a credit card, the worse one’s credit score will be. Spending judiciously will keep those numbers in line and enhance the likelihood of getting approved for the loan.