If you have never applied for a commercial mortgage loan before, you may have the misguided idea that this is not too different from a residential mortgage. This is not so.
Unlike most residential mortgages, commercial business loans are not backed by a loan guarantor like Fannie Mae. This makes them inherently riskier for the lending institution. Thus, commercial lenders have no real choice but to be more conservative in their lending practices. In practice, this means they charge higher interest rates, often want a larger down payment and frequently want more information about the business than a small business owner might expect if they are basing their expectations upon their experience with purchasing a home for residential use.
Balloon Loans are Common
At one time, balloon loans were common for residential mortgages as well. This is no longer true. However, they are common for commercial mortgages. This means you make payments as if for a 30 year mortgage for 3, 5 or 10 years and then you owe the balance in a large lump sum.
In practice, they are frequently refinanced when the balloon payment comes due. If you cannot qualify for refinancing at that time, perhaps due to a downturn in sales or perhaps because the lender simply wants to diversify their loan portfolio, you are at risk of foreclosure.
For many businesses, it is well worth it to pay a slightly higher interest rate in order to get a 20 or 30 year mortgage instead of a balloon loan. This provides more stability for the business. You may need to go to a non-bank lender to get a commercial loan that has no balloon payment.
Commercial loans from banks typically require a down payment of 20 to 25 percent. This means that if you are buying property worth $500,000, you would need to put down $100,000-$125,000.
However, some lenders will allow you to borrow 85 to 90 percent of the value of the property. These are usually not banks. In most cases, these are offered by direct commercial lenders or commercial investors. The interest rate for such loans if often a little higher than a traditional bank loan with a 20 to 25 percent down payment.
Studies have shown that cash flow issues are the single biggest reason why small businesses fail. Thus, it may be well worth it to get a loan with a smaller down payment so you can have a larger cash reserve on hand.
Commercial Loans Take More Time than Residential Mortgages
Although many small business owners will contact their bank first, your bank will likely be the slowest means to secure a loan. It can take weeks to get a letter of commitment from a bank. Furthermore, even after this letter is issued, the loan may still not be forthcoming because the loan committee may veto it. If you are in no hurry, have a good relationship with your bank, excellent credit and are not intimidated by providing substantial documentation, a bank loan can net you the lowest interest rate. But, for many businesses, the time involved and documentation process is excessively cumbersome and not worth it.
If you are in a hurry to get pre-qualified, non-bank sources are a better bet. They are also the best place to go if you know you will have a hard time providing the paper trail a bank will desire or if you do not have a great credit score. You can even start your search online, just make sure that you are looking for commercial mortgages, not residential ones.
Covenants and Conditions
These may be new terms for you. This is an area where commercial mortgages are substantially different from residential mortgages.
After you have qualified, the on-going burden of a residential mortgage is mostly just making the payments on time and in full. But commercial mortgages often have other provisos, such as requiring you to provide income statements, balance sheets or tax returns on a regular basis.
They may also stipulate that the business must meet certain performance criteria, such as having positive cash flow. This means that if there is a recession, you may be in violation of your mortgage terms even if you manage to make your mortgage payments. This can result in foreclosure and the loss of your business.
Every lender has its own set of conditions. Ask around and try to find a lender whose conditions are such that you feel you can comfortably meet those terms for the foreseeable future. Getting a contract that makes sense for your business situation is the best way to make sure that the mortgage terms do not kill your business.
Papers, Papers, Papers
You know the saying in real estate: Location, Location, Location. The mortgage industry could well have an equivalent saying about the paperwork. Here are just some of the documents you may need to produce in order to complete the loan process through a traditional lender:
- A copy of any lease agreements
- Asset statements
- Incorporation documents (originals)
- The business owner’s personal financial records
- Tax returns and other financial statements going back 3 to 5 years
If you are unfamiliar with commercial business loans, they have many fees that are not typical for a residential mortgage or other types of loans. This fact can make you feel blindsided if you aren’t expecting all the additional fees. Here are some fee types to look out for when trying to figure out how much the loan is really going to cost you:
- Legal fees
- Loan application fees
Many of these items must be prepaid. This is part of why they can be so painful because you have to come up with the cash before you get the loan in order to get the loan at all. So, make sure you have a good idea of how much money needs to be brought to the table to cover the closing costs.
Early Repayment and Assumable Loans
One clause you should keep an eye out for is a pre-payment penalty. This can interfere with paying the loan off early if you find yourself in the money or selling the property. Commercial mortgages frequently have such a clause. To offset it, some of them are assumable, which makes the property easier to sell by making sure that the existing mortgage can go with it.
You should generally look at all of the details of the loan with an eye towards how it limits your future options. Your business performance is always a moving target. The loan details may make the loan payments a moving target as well, such as if it has a variable interest rate instead of fixed. This may cause your payments to go up if interest rates go up.
You should consider both best and worst case scenarios for your business and how the terms of the loan would impact your ability to make pertinent business decisions. Make sure you understand every clause and detail of the loan contract and brainstorm some ways this may impact your business under different scenarios.
If you come across a situation where a particular scenario seems likely to you and the details of the loan would be a significant problem in that particular scenario, consider seeking a loan with more favourable terms. Low-interest loans sometimes have the most problematic terms, thus, they may not be worth the risk involved. A bad loan can cost you your business.
Images: ” Businessman hand touching COMMERCIAL LOAN tab on virtual screen /Shutterstock.com“
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