There are several differences between residential and commercial loans. And it’s helpful to know these differences before selecting a property.
- Entities vs. Individuals
- Different Types of Income Matters
- Interest Rates
- Loan Terms and Amortization Period
- Penalties May Occur With Commercial Mortgages
1. Entities vs. Individuals
With commercial mortgages, loans are typically made between a commercial bank and a company, whereas residential mortgages are usually made between the bank and an individual.
Commercial real estate mortgages are typically made to various business entities (such as LLCs, LLPs, funds, trusts, etc…) which were formed for the specific purpose of purchasing commercial real estate. These entities may not have a strong financial history or a long history of credit, whereby the lender may require the owners of the entity to personally guarantee the loan. As a result, the lender now has an individual (or group of individuals) with a strong credit history and ultimately, individuals from whom they can recover if the loan were to default. However, if the lender does not require the loan to be guaranteed by the individuals named in the business, the property itself would be set as the means of recovery in the event of a default (this is called a non-recourse loan, which you often see with Solo 401(k) investments).
2. Different Types of Income Matters
When applying for a mortgage, lenders are going to look at different types of income depending on if you’re applying for a commercial or residential mortgage. With a residential mortgage, banks will often look at an individual’s Debt-to-Income ratio. In other words, the bank will look specifically at your personal gross income compared to the amount of debt you owe. Typically, lenders like your debt to be no more than 45% of your gross income. (In other words, if you make $100,000 in gross income, they don’t want you to have more than $45,000 in debt). Additionally, lenders often do not want your mortgage payment to be no more than 28% of your monthly gross income.
For commercial mortgages, lenders will look at the property’s ability to generate income, compared to its debt. This is called Debt Coverage Ratio (DCR). A DCR of 1:1 would mean that a property earns what it owes. For example, if a property has a mortgage of $1,000 per month and earns $1,000, it has a DCR of 1:1. Lenders usually like to see a DCR of 1:1.25.
3. Interest Rates
Commercial loans typically have higher interest rates than residential rates because they are considered by banks to be at higher risk than residential mortgages. For example, if a person who owns both a residential and commercial property falls upon hard times, he will typically pay off his residential mortgage (so that he still has a roof over his head) while the commercial property mortgage may fall by the wayside. Additionally, there is a smaller secondary market for commercial loans, which means that banks typically hold on to the loan for the entire term (see below) and thus, increases their risk.
4. Loan Terms and Amortization Period
Borrowers who opt to use residential loans usually finance their properties over a lengthy period of time, such as the ever-so-famous 30-year loan term. As a result, these loans are typically repaid in regular increments over a period of time. Because of the longer amortization period, borrowers of residential loans usually have lower monthly payments (and conversely higher interest across the lifespan of the loan) which provides borrowers with more working capital each month.
By contrast, because the risk is higher, the terms for commercial loans are typically shorter (5 years – 20 years, but typically 10 years) and the amortization period is often longer than the loan term. For example, a lender may make a commercial loan for a term of 10 years with an amortization period of 30 years. In this hypothetical, the investor would make standard payments for 10 years based on the loan being paid of over 30 years, followed by a final balloon payment of the remaining balance of the loan.
Typically, residential loans can be paid off early or at a rapid rate without penalty. However, it’s important to recognize that commercial loans may have different restrictions on prepayment. These restrictions are designed to preserve the lenders’ anticipated yield on the loan while also preserving the level of risk on the lender. Occasionally, the prepayment penalties on a commercial loan occur on a sliding scale, decreasing in the amount as a percentage of the loan each year.
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