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Commercial Loans vs Residential Loans: Do you know the differences?

Commercial Loans vs Residential Loans: Do you know the differences?

Commercial Loans vs Residential Loans: Do you know the differences?

Key word: Commercial Loans

Commercial loans, residential loans

John and Jane want to buy piece of property to house their new business, “John and Jane’s Jams and Juices” and they need a commercial loan. Sounds simple, after all, they bought their house and they have been through the residential mortgage process. Isn’t it the same? The simple answer is no. But we are going to give you the long, not so simple answer as well. Let’s look at how commercial loans compare to residential loans.

 

How commercial loans and residential loans are similar:

 

Both commercial loans and residential loans use the property being purchased as collateral. In other words, if the borrower fails to make the payments, the purchased property falls to the lender. But that’s where the similarities tend to end.

 

Commercial loans to companies, residential loans to people:

 

Lenders typically make residential loans to individuals. When John and Jane bought their house, their bank loaned directly to John and Jane, the individuals. But in a commercial transaction, the loan is made to a company.  So, if John and Jane Smith find the perfect property to house their “John and Jane’s Jams and Juices”, they would form a company and borrow the money as that company, not as individuals.

 

What lenders look at in residential loans:

 

When John and Jane bought their house, the housing market was strong, so they were able to negotiate the amount of money they would put down on their house. The lender also looked at John and Jane’s debt ratio. They wanted to make sure that debt consumed no more than 45 percent of their gross income and that the house they were buying would represent only 28 percent of their total debt.

 

What is considered in commercial loans:

 

In deciding whether or not to make “John and Jane’s Jams and Juices” a commercial loan, the lender will look at the proposed property’s ability to earn income compared to the amount of the requested loan. The fancy schmancy term for this is Debt Coverage Ratio (DCR). A DCR of 1:1 would mean the property earns what it owes. Lenders want to see a DCR of 1:1.25. Also, whereas a residential loan is primarily about income vs debt and credit history, a commercial loan is about business. John and Jane would have to present a business plan for “John and Jane’s Jams and Juices” when they apply for their commercial loan.

 

Commercial loans are higher risk than residential:

 

Even if, John and Jane’s Jams and Juices are the very best in the world, lenders would consider their commercial loan higher risk than their residential loan.  Statistically, commercial loans ARE riskier than residential. Homeowners usually make sure their mortgage is paid first. They will put off other bills to keep the mortgage paid on time. That’s not always the case for commercial loans, therefore “John and Jane’s Jams and Juices” will probably pay a higher interest rate than John and Jane, homeowners.

Shorter payback periods for commercial loans

 

John and Jane’s commercial loan will also have a ten-year payback period, compared to their 30-year residential loan. Commercial loans can range from five to 20 years, but most run 10 years. And while mortgages too, can be shorter or longer than 30 years, by far, the most common residential loan carries a 30-year payback schedule.

 

If John and Jane win the lottery and decide to pay off their residential loan 15 years ahead of time, the lender will accept the payment, shake their hands and hint that he could sure use a new sports car, if only some lotto winners would buy it for him. But—he would not penalize John and Jane for paying off their loan early. There is no penalty for early repayment of residential loans. people often refinance when interest rates drop; charging an early pay-off fee isn’t cost effective.

 

Penalties for paying off a commercial loan early

 

It’s a different story for John and Jane’s Jams and Juices. If Oprah Winfrey tries their jam and and declares it one of her favorite things, and suddenly the business is a huge success, John and Jane should not necessarily pay off their commercial loan. Paying back a commercial loan early will almost always cost you prepayment fees.

 

If you are in the process of purchasing a residential or commercial property, we can help.

At Landmark Title we offer personalized title and escrow services for both commercial and residential transactions. If you have questions about our services or need assistance with a real estate transaction, please call us at (602) 768-2800 or visit our website.

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