Commercial Loans: Definition, Types, How They Work

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About 43% of small businesses applied for a loan in 2018, and nearly half received the full amount of funding needed. This type of financing is known as a commercial loan since it appeals to companies, not individuals. Businesses may use these funds to expand their operations, purchase equipment or develop new products. Before jumping onto the bandwagon, make sure you know how commercial loans work, when to apply for one and how to increase your odds of getting approved.

What Is a Commercial Loan?

As a small-business owner, you may need capital to hire talent, invest in new technologies or cover ongoing expenses. One option is to reach out to angel investors and venture capitalists, but you risk losing control of your business. A commercial loan does not pose this risk. However, getting one comes with its challenges.

Commercial loans are a type of financing aimed at business customers. The funds are typically used to cover operational costs or to finance major expenditures such as product development and manufacturing. Business owners may take out a commercial loan from traditional banks, online lenders, credit unions and other financial institutions.

According to a Federal Reserve survey, 49% of companies applied for loans through a large bank. More than one-third of applicants reached out to online lenders, and 9% used credit unions. Medium- and high-credit-risk businesses are more likely to apply through online lenders, which typically offer more flexible terms than traditional banks.

Commercial loans are considered a short-term financing option. Depending on the type of loan for which you apply, you may need to pay it back in as little as 30 days. In general, the term of a loan depends on the security you offer to the bank. Commercial real estate loans, for example, have to be paid back within five to 20 years, but these terms are often negotiable depending on your credit strength.

How Does Commercial Lending Work?

Unlike residential loans, which are designed for individuals, commercial loans appeal to small- and medium-sized companies, corporations, real estate developers, trusts and other business entities. Both banks and private commercial lenders may offer this funding option. Several types of commercial loans exist, each having different rates, terms and eligibility requirements.

With this financing option, borrowers pay back interest, principal loan amounts and certain fees over several months to several years. Long-term commercial loans, for instance, are typically above $1 million and have to be paid back within five to 10 years. They are often used for major capital expenses. Short-term loans, by contrast, allow small businesses to borrow small amounts of money ($5,000 to $250,000) and must be repaid within three to 18 months or so.

Commercial loans may or may not require collateral depending on their type and the loan amount. How much money you can borrow depends on several factors, including your business size and industry, credit score, financial history and more. For example, commercial lenders may want to see your business plan and personal credit if you want to take out a loan for a small company or a startup. You may also need to make financial forecasts and have a minimum viable product idea to increase your odds of getting approved.

One of the most important factors to consider when applying for a commercial loan is your credit score. Business owners with a personal credit score of 680 or higher and at least $250,000 in annual revenue have greater chances of success. Depending on the type of loan for which you apply, the bank may want to check your tax returns, financial records and books over the past five years and check the credit reports of the company and its owners or partners.

Types of Commercial Loans

Commercial loans come in all shapes and sizes. There are commercial real estate loans, small-business loans, equipment and vehicle loans, loans guaranteed by the Small Business Administration and more. Business owners may also consider the following options:

  • SBA 7(a) loans
  • SBA 504 loans
  • Commercial mortgage loans
  • Real estate bridge loans
  • Construction loans
  • Medium-term, short-term or long-term loans

Equipment loans, for example, have a repayment term of one to five years and interest rates of up to 30%. Depending on your credit strength, you may receive up to 100% of the equipment value. This type of financing is quite similar to a car loan and can be used to purchase machines and accessories for manufacturing, farming, restaurants and more. The lender may want to see your business plan, cash-flow statement, profit-and-loss statement, balance sheet and other relevant documentation.

Some businesses, such as shopping malls and hotels, may need financing to purchase, build or renovate properties. That's where commercial real estate loans come in handy. With this option, you can get anywhere between $200,000 and $20 million to invest in new office buildings, retail space, warehouses and so on. The repayment term is 20 to 25 or 30 years.

Interest rates for commercial real estate loans vary from one lender to the next, but you can expect to pay around 5% to 30%. Your new property will serve as collateral. These types of loans can be broken down into several categories, including but not limited to business mortgage loans, hard money loans (which are typically offered by private investors), real estate bridge loans, construction loans and blanket loans.

How Do SBA Loans Work?

As a startup or small business, you may find it difficult to get traditional bank loans. Commercial lenders need some sort of guarantee that your business will generate profit and afford to pay off debt. According to the Federal Reserve survey, about 9% of commercial loan applications were declined in 2018 because of poor credit strength, insufficient collateral, no credit history, weak business performance or excessive debt.

One way to overcome these barriers is to contact the SBA and inquire about Lender Match, its loan program designed for startups and small companies. The SBA doesn't lend money to entrepreneurs, but it makes it easier for them to access capital. With Lender Match, small business owners can find lenders offering competitive terms and flexible eligibility requirements.

Any for-profit business based in the U.S., including those with bad credit, may apply for SBA-guaranteed loans and receive $500 to $5.5 million. The funds can be used for most business purposes depending on the lender. However, if you have access to other financing methods with reasonable terms, you may not qualify for this type of loan. If you do qualify, be prepared to deal with extensive paperwork and to put up some kind of collateral.

SBA 504 vs. 7(a) Loans

The SBA provides access to several types of commercial loans for small businesses. Two of its most popular loan programs include the SBA 504 and the 7(a). Each has distinct characteristics and offers unique benefits to companies that qualify.

SBA 7(a) loans can be used to finance startups and for business acquisitions, equipment and machinery, working capital, debt refinancing and more. With the SBA Standard 7(a), business owners can borrow up to $5 million. Those who need less than $25,000 are not required to put up collateral.

If you need no more than $350,000, you may apply for the SBA 7(a) Small Loan. Other options are the SBA Express program, Export Express, Export Working Capital and International Trade loans.

Business owners who are planning to make major purchases or investments may want to consider the SBA 504 loan. This financing option has several key features, including a 10% to 20% down payment, 10- to 25-year repayment terms and low fixed-interest rates. The funds can be used for purchasing buildings, heavy machinery, land and other major fixed assets. It appeals to companies that have been in business for two years or longer and have reported an average net profit of less than $5 million over the last two years.

Applying for a Commercial Loan

The application process depends largely on the amount and type of loan. As you would expect, getting capital for a startup or a small business isn't easy. Proper preparation is the key.

First, determine how much money you need and how you're planning to use the loan. Do you need additional cash flow, or do you want to grow your business? Include the purpose of the loan in your business plan. Next, prepare the documents required to apply for a commercial loan, including your tax returns, bank statements, balance sheets, financial projections, lease and/or tenancy agreements (for commercial mortgages) and more.

Make a list of lenders that meet your requirements, compare their offerings and decide what type of commercial loan best suits your needs. Wells Fargo, Capital One, JPMorgan Chase and Bank of America all offer business loans. Compare them side by side, read customer reviews and contact them for more information on how to apply and what documents are necessary.

Your Personal Credit Score Matters

Commercial lenders will check both your personal and business credit scores when reviewing your application. Although there is a clear distinction between your personal and business finances, your personal credit rating matters too. This number provides insights on your spending habits and may be used to assess your creditworthiness. It's calculated based on several factors, such as your payment history, any debts you owe, the type of credit you use and more.

Generally, a personal credit score below 680 is considered low and may affect your ability to take out a loan. Aim for a credit score above 700 to increase your odds of approval. Although the SBA and online lenders may accept a credit score of 650 and up, it's better to stay on the safe side.

Consumers can check their credit scores for free once per year, so make sure you do so. This may help you identify potential errors and fix them before applying for a personal or commercial loan. If your credit score is low, there are ways to improve it. Always pay your bills on time, keep your balances low on credit cards and apply for new credit accounts only as needed.

Build Business Credit

Next, work on building or improving your business credit score. This number ranges from zero to 100 and depends on your payment history, trade experiences, company size, nonfinancial transactions, balances on outstanding loans and more. Certain factors, such as the presence of bankruptcies and liens on your business profile, may affect your credit rating.

Just like with your personal credit score, it's recommended to check your business credit report at least once a year. To do so, you need to contact major credit-reporting agencies like Experian and Equifax. They will give you access to your credit report in exchange for a fee. Experian, for instance, charges $39.95 for this service.

The best way to build business credit is to keep your company's finances separate from your personal finances. Open a business bank account, apply for a credit card and use it for business transactions. Consider taking out a microloan and pay it back on time. Establish credit accounts with the vendors with whom you work, register with the major credit-reporting agencies and make payments to creditors before the due date.

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About the Author

Andra Picincu is a digital marketing consultant with over 10 years of experience. She works closely with small businesses and large organizations alike to help them grow and increase brand awareness. She holds a BA in Marketing and International Business and a BA in Psychology. Over the past decade, she has turned her passion for marketing and writing into a successful business with an international audience. Current and former clients include The HOTH, Bisnode Sverige, Nutracelle, CLICK - The Coffee Lover's Protein Drink, InstaCuppa, Marketgoo, GoHarvey, Internet Brands, and more. In her daily life, Ms. Picincu provides digital marketing consulting and copywriting services. Her goal is to help businesses understand and reach their target audience in new, creative ways.