Commercial loan vs. Residential loan – Top Differences
There are several ways to finance real estate investments, so you don’t have to dip into your savings (which may be in the bank, a safe, the freezer, or under the mattress, depending on your personal preferences). As a rule, they call for the ideal form of expenditure: spending other people’s money.
This article explains the differences between commercial and residential loans, the two most typical types of real estate finance.
Commercial loan
Commercial real estate loans are mortgages backed by liens on commercial properties rather than single-family residences. “Commercial real estate” (CRE) is a term for buildings that make money for their owners through housing businesses.
A commercial real estate loan (CRE loan) could be helpful for a small business owner who wants to improve or expand their current location. Companies, developers, partnerships, funds, trusts, and REITs are the typical borrowers of CRE loans. This means that there are legal entities whose sole mission is to own and manage commercial properties. To generate revenue, the company buys commercial real estate, sublets space to other companies, and charges those other companies rent. Commercial real estate loans are used to fund the whole project, from land purchase and development to building construction.
Commercial loan benefits
Capital gains
It is possible to make a sizable profit by investing in commercial real estate. Because real estate values almost always rise in the long run, this strategy can help you realize capital gains over time.
Renting potential
You can make more money from your property by renting out any space that is not being used.
Financial planning
Commercial mortgage payment plans often cover a more extended period, which frees up a company’s resources to be used in other ways to grow the business, like advertising, cutting costs, hiring and keeping skilled workers, etc.
No ’empty money’ rent payments
Typically, the monthly cost of a mortgage payment is the same as or less than the cost of renting a comparable home. On the other hand, if you already own the property, your financial footing will be even more secure as your equity in the building increases with each mortgage payment.
Ending a mortgage
If you have a commercial mortgage and run into financial difficulties, need to relocate to larger quarters, or choose to shut down your business, you still have options. Although it may be challenging to terminate a long-term lease, a mortgage can be paid off by either selling the property or renting it out and maintaining it.
Lower interest rates
It’s common for commercial mortgage interest rates to be lower than the rates offered on unsecured personal loans. If you choose regular monthly payments, you’ll always know how much money is coming in and going out of your firm. This makes it easier to manage the financing of your venture.
Residential loan
A residential loan is a loan provided by a bank, mortgage business, or other financial institution toward the acquisition of a single-family dwelling, a second home, or an investment property. In exchange for a loan, the owner (the borrower) gives the property’s title to the lender (the mortgagee), with the understanding that the title will be given back to the owner (the mortgagee) when all payments are made and other conditions of the mortgage are met.
Borrowers often get residential loans to pay for the purchase, construction, improvement, or renegotiation of a primary or secondary home. The standard residential loan covers financing for single-family homes, condos, co-ops, and townhomes. However, four-unit apartment buildings are also included in the residential lending market. All units need to have a kitchen and a bathroom. Loan providers classify multi-family buildings with five or more units as commercial.
Since the down payment on a property is usually not required, home mortgages make home ownership available to a far larger section of the population. A lender can foreclose on a property (i.e., seize it from the homeowner, then sell it on the open market) if the borrower stops making payments while the mortgage is in effect since the lender has legal title to the property.
Residential loan benefits
Low-Interest Rate
A lender’s primary concern is the default, which means the borrower can’t repay the loan. A low-interest rate on a mortgage loan is fair because the lender has a security interest in the home as collateral in case the loan isn’t paid back.
Benefits in Tax
Borrowers are eligible for income tax breaks when they finance a home. If one deducts the interest paid from their taxable income, the amount owed to the government is reduced.
Ease in Repayment
When you get a residential loan, you shouldn’t expect to pay it off all at once. Loans are often repaid over the course of several months. It’s easier to make a monthly payment when it’s less than one’s monthly income. The schedule for paying back the loan is flexible and depends on how old the borrower is and how many years are left until retirement.
Commercial loan vs. Residential loan – Top Differences
Individuals vs. Entities
Business entities are more common borrowers for commercial real estate loans, as opposed to individuals, who often take out mortgages on residential properties (e.g., corporations, developers, limited partnerships, funds, and trusts). Forming a legal corporation only to acquire commercial property is a common practice.
If a company doesn’t have a credit history or track record, its founders or principals may need to guarantee a loan to get financing personally. If the borrower (or borrowers) defaults on their loan, the lender now has someone from whom to seek repayment. The loan is considered non-recourse if the lender does not require a personal guarantee and the collateral is the only source of recovery in the event of default.
Loan Repayment Schedules
The “amortization period” is the total length of a loan, while the “amortization schedule” is the exact plan for making monthly payments to pay off the debt. Lenders base their interest rates on several factors, including the loan’s tenure and amortization schedule. These terms may be flexible depending on the investor’s creditworthiness. As a rule, the interest rate on a loan will increase if the payback period is stretched over a longer period.
The typical amortization term for a residential loan is 15 to 30 years (though this can be shortened if the loan is paid off early), whereas the average for a commercial mortgage is much lower. Commercial loans have maturities anywhere from five to twenty years. Also, the time it takes to pay back a commercial loan is usually longer than the length of the loan, while the time it takes to pay back a residential loan is usually shorter. On the other hand, as a business borrower, you may be able to negotiate a repayment plan that better suits your needs.
Qualifications
Loan eligibility for residential property is determined mainly by the borrower’s financial situation, whereas the property’s expected cash flow determines commercial property eligibility. The less weight your personal income has in receiving a business loan, the higher the property’s value must be for you to get one. To make your loan application more likely to be approved, you need to know how the underwriting process works and what documents you’ll need to send with your request.
Loan-to-Value Ratios
The loan-to-value ratio (LTV) is a metric that compares the total loan amount to the property’s current market value; it is calculated differently for commercial and residential loans. LTV is determined by the lender dividing the loan amount by the lower of the property’s appraised value or the purchase price.
Some home mortgages might have a high loan-to-value ratio. LTV ratios of 100% or less are permitted for VA and USDA loans, 96.50% or less for FHA loans (Federal Housing Administration-insured loans), and 95% or less for conventional loans (those guaranteed by Fannie Mae or Freddie Mac).
In contrast, the typical LTV for a commercial loan is between 65% and 80%. However, loans with higher LTVs do exist, though they are unusual. The particular LTV ratio usually varies between loan types. A loan-to-value (LTV) of 65% may be acceptable for undeveloped land, while a figure of 80% could be considered appropriate for multifamily development.
Interest Rates and Fees
Standard interest rates for commercial loans are higher than those for residential loans. The total cost of a commercial real estate loan can go up by a lot if you have to pay for things like an appraisal, legal services, a loan application, the loan’s origination, and maybe even a survey. Up-front fees must be paid to receive the loan (or lack thereof), and yearly fees must be paid regardless of the loan’s status.
Source
Residential loans are available from the most prominent financial institutions and national mortgage companies. On the other hand, commercial loans are typically obtained from local banks, ideally, ones with which you already have a working relationship.
Down payment
The standard down payment for home loans is 25%. In the case of commercial loans, a larger initial deposit may be necessary. This is especially true if you don’t already have a “seasoned relationship” with the lender. That’s why it’s so crucial to establish ties with local banks right away.
Fixed vs. Variable
Most residential loans have a fixed interest rate for up to 30 years. When you lock in an interest rate, your rate and payment will not change, no matter what happens to interest rates. In contrast, interest rates on commercial loans are often subject to change. Your interest rate will rise and fall in tandem with a specified index. It reduces the lender’s risk, similar to a shorter amortization period since your mortgage payment will increase similarly if interest rates do.
The Bottom Line
When deciding between a home loan and a business loan, it’s easy to get lost in the details. No amount of forethought can definitively tell which of those two financing choices is ideal for your property investment. Seeking professional help is necessary.