In this week’s edition of the frequently asked question blog series, we will address the concept of, “Top Commercial Lending Terms To Know”. As you navigate the process of securing commercial financing, lenders will utilize a host of terms so it's important to familiarize yourself with them. Below I've provided the most common:
Interest rate
This is likely the first term lenders will share with you. Your interest rate dictates how much interest you will pay based on the remaining balance of the loan. Depending on how much you borrow, a slight difference in interest rate can have a huge impact on how much interest you pay over the life of the loan. For example, if you take out a million-dollar loan at a 4% interest rate with a 20-year loan term, you would save almost $130,000 in interest payments versus taking out an equivalent loan at a 5% interest rate. Therefore, consider which banks offer the most competitive interest rates to ensure you maximize returns over time.
Loan Term
The next item to consider is the "loan term". A loan term defines how long your interest rate will remain fixed. In residential real estate, the term of a loan is as long as the amortization period (will discuss this term next). Therefore, if you buy a home on a 30-year note, it's going to have a term of 30 years. However, In commercial real estate that's not the case. Generally, loan terms range from 5-20 years with 5-10 years being the most common. Once the term expires, the loan will either come due via a balloon payment (i.e. a one-time sum that pays off the remainder of your loan balance) or your interest rate will begin to float, meaning your interest rate will begin fluctuating based on a particular index. This adjustment occurs every 6-12 months. In our current low-interest-rate environment, having a longer loan term is usually the best option. This is because interest rates will likely rise in the future, thus, locking in a low rate may be beneficial.
Amortization Period
The number three thing to consider is your "amortization period". The amortization period of a loan is how long the payments are spread out over. Unlike residential real estate where loan amortization periods are typically 30 years, commercial loans range from 15-25 years. As a rule, the longer the amortization period of a loan, the lower your mortgage payment will be. Because of this, business owners and investors who prioritize maintaining solid cash flow will usually elect to go with longer amortization periods. Having said that, longer amortization periods also mean that you will pay more interest over the life of the loan. Therefore, if your priority is to pay as little interest as possible, electing to go with a shorter period may be your best approach.
Loan Sizing
Number four thing to consider is a term called "loan sizing". This is a process whereby a lender determines how large of a loan they will give you based on a variety of factors. Typically, banks utilize two methods to determine your loan amount. First, banks set "loan to value ratio" (LTV) requirements for their commercial loans. A loan to value ratio is a proportion that compares how much debt is on a property compared to its value. This is usually expressed as a percentage. For example, if a property is worth $1,000,000 and a bank's LTV is 80%, the largest loan they will issue is $800,000.
The second method banks use to determine loan size is the "Debt Service Coverage Ratio" (DSCR) calculation. A property's DSCR is a calculation that compares a business's net operating income to its yearly mortgage obligation. The ratio is typically expressed in a decimal format and each bank has its own independent requirements. However, it is usually dependent on how consistent the cash flow of your business is. For example, if your total mortgage payments for the year equal $100,000 and the bank has a 1.25 debt service coverage ratio requirement, your business will need to have a yearly Net Operating Income of at least $125,000 in order for the bank to loan you the money.
Typically, banks compare the loan amounts generated from the LTV and DSCR calculations and will give you the lower of the two. Therefore, consider how each lender determines their final loan amount so you get a better idea of what you will qualify for.
Pre-Payment Penalty
The final item to consider is a loan's "prepayment penalty". Prepayment penalties are fees that are assessed to a borrower for paying off their loan balance within a certain timeframe. For example, a bank may elect to charge a fee if a borrower pays off or refinances their loan within the first 5 years. The reason banks institute these fees is because there are costs associated with issuing a loan. Additionally, banks make money from loaning funds to business owners and investors. Therefore, to dissuade borrowers from stopping their flow of interest payments, they institute some form of prepayment penalty. Pre-payment penalties are typically assessed as a percentage of the original loan amount.
Sometimes banks will charge a flat rate, say 2% of the loan amount, for the first 5 years of the loan. Therefore, if you take out a $1,000,000 loan and then you refinance two years later, you would be subject to a $20,000 penalty. Other banks charge a graduated prepayment (i.e. 5% the first year, 4% the second year, 3%, the third year, etc.) Therefore, if we use the previous example and you refinance in year 3, you would be subject to a $30,000 penalty. When speaking with lenders, be sure to ask what pre-payment penalties, if any, are associated with the loan. Additionally, consider asking that pre-payment penalties be removed or significantly reduced. Although some banks may push back, others may be willing to accommodate.
If you're in the market to buy, lease or sell commercial property in the Louisville Metro and Southern Indiana region, feel free to reach out to me call me at (502) 536-7315 or you can email me at raphael@gristanigroup.com. Looking forward to hearing from you!
P.S. If you're a business owner interested in leasing commercial property, be sure to grab a copy of my book "Before You Sign That Lease: The Small Business Owner's Guide To Leasing Commercial Space". To buy your copy, click the following link: