Debt financing to support a predetermined business purpose or expenditure
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A commercial loan is a form of credit that is extended to support business activity. Examples include operating lines of credit and term loans for property, plant and equipment (PP&E).
While there are a few exceptions (including commercial property owned by an individual), the overwhelming majority of commercial loans are extended to business entities like corporations and partnerships.
Private businesses that have financing needs generally borrow from a commercial bank or credit union; however, they may also seek credit from equipment finance (leasing) firms or other private, non-bank lenders (like factoring companies).
A commercial loan is credit earmarked for a specific business purpose or expenditure.
Commercial loans tend to have much more complicated credit structures than personal loans.
Three of the most common types of commercial loans are lines of credit, term loans, and commercial mortgages.
Commercial loans are often secured, meaning that they’re backstopped by physical collateral.
Understanding Commercial Loan Structure
Most lenders don’t extend credit in perpetuity or without some very specific purpose for the funds being advanced. This is what bankers often refer to as loan structure (or credit structure).
The following are some examples of questions that a lender should ask themselves when structuring a commercial loan:
Will the financing be revolving/operating credit or reducing term debt with scheduled repayment intervals?
What (if any) assets will serve as collateral for the exposure? (Note: if a loan has collateral it is said to be a secured loan)
What is the maximum loan-to-value (LTV) we’re willing to offer against the asset being financed?
What is an appropriate amortization period based on the purpose of the commercial loan?
What should the interest rate be in order to compensate for the borrower’s projected default risk?
Most commercial loans extended by traditional financial institutions are secured by collateral.
Types of Commercial Loans
There are many forms of credit available to support businesses but we’ll look at some of the most common types:
Lines of Credit
An LOC (often referred to as a “revolver”) supports the working capital cycle for firms that sell on credit terms. There is no set repayment schedule; it’s structured to revolve up and down as balances change in the company’s working capital accounts.
Term loans are used to acquire non-current assets, which include things like equipment, vehicles, and furniture. Term loans are typically amortizing, meaning they reduce with periodic payments (often monthly). At the time of loan advance, both the borrower and the lender will have already agreed upon a repayment schedule. The loan repayment period is generally aligned to the useful life of the underlying asset being financed.
Capital leases – sometimes referred to as “finance leases” – serve a similar purpose to term loans (meaning they’re used to finance non-current, capital assets like equipment). The main difference between a term loan and a capital lease is that the equipment finance firm funding the lease retains the legal title of the physical asset (as opposed to registering a lien over it).
Commercial mortgages are another type of term lending but they’re used exclusively to finance (or refinance) commercial real estate. The analysis and underwriting techniques vary depending on whether the property is owner-occupied or if it’s an income-producing investment property; however, both tend to have more flexible terms (longer amortization, more favorable LTVs, very competitive pricing, etc.) than other types of commercial loans.
Acquisition loans are another category of commercial loan. These are used by businesses that are buying other businesses (or other business divisions) as opposed to physical assets like property or equipment. While not universally true, acquisition loans tend to have shorter amortization periods and lower loan-to-values than other types of commercial loans.
The Commercial Loan Process
At CFI we teach the credit process as having 5 distinct steps. These are:
Loan origination, where the relationship team goes out and prospects for potential borrowing clients.
Client discovery and credit structure is where the team of lenders (including the relationship manager and the credit analyst) seek to understand the health of the business, what its specific borrowing needs are, and how the deal might be structured and priced.
Analysis and underwriting occurs once the team has secured the client’s commitment to move forward on a formal credit application. At this stage, the bank’s adjudication team (or credit committee) must provide final approval of the proposed credit structure.
Documentation and perfecting security begins once the deal has been approved, the loan agreement executed, and any liens against the business and its assets registered correctly by the lender’s counsel.
And finally, the loan is advanced and the borrower gets access to the loan proceeds.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers in banking to the next level. To keep learning and advancing your career, the following resources will be helpful:
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