As a real estate investor, pursuing income streams to match your financial goals, budget, and qualifications is essential. Most real estate investors do not purchase a property entirely and therefore depend on loans to finance their purchase. When seeking to invest, one faces a decision: should I invest in commercial or residential property?
In the eyes of the bank, this is the equivalent of asking, will I be getting a commercial or residential loan? So many investors have questions like what a commercial loan is, how to get a commercial loan, and what is a commercial loan process compared to residential loans.
In this article, we outline everything you need to know about commercial and residential loans and the seven key differences that set them apart.
What is a commercial loan?
A commercial loan—or commercial real estate loan—is essentially a way of getting a loan for business purposes and refers to buildings used for offices, shopping centers, hotels, and more. These loans for businesses are taken out by companies that seek to generate profit from the property, whether it is the business owner or a real estate investor who will rent out the commercial spaces.
What is a residential loan?
By contrast, a residential loan applies to purchasing a home, or residential property, such as your primary residence. However, for real estate investors, purchasing a residential property for investment purposes would qualify as a commercial deal and require a commercial loan.
What are the differences?
There are significant differences between the commercial loan process, commercial real estate loan requirements, and the cost of getting a commercial loan compared to its residential counterparts. Some of the critical factors that differ between business loans and residential loans are the following:
- Amortization period
This represents the length of the loan. With commercial real estate lending, this period is often much shorter, set somewhere between under 5 years through to 20 years, with the expectation that the property will be paid off more quickly. When it comes to residential properties, the most common length is 30 years, with lower payments over a more extended period.
- Loan to value ratio
Residential and commercial lenders use this financial metric to show the loan’s value in relation to the property value, also known as LTV or the Loan to Value Ratio. How is the loan to value ratio determined? This figure usually falls between 65-85% for business loans, whereas, for residential properties, the LTV is often much higher. For example, VA and USDA mortgages may see an LTV as high as 97-100% .
- Repayment schedule
Because of the differing amortization period, commercial loan requirements typically set a repayment schedule over 20-25 years, depending on the commercial lender and commercial property type, as some can even amortize for 30-35 years. On the other hand, for residential loans, expect to pay consistent installments at a fixed rate over 15 or 30 years, with a more extended period representing higher interest rates but lower payments.
- Interest rates and fees
Commercial loans often have higher rates, contributing to higher payments. This factor makes it harder for some investors to be eligible for a commercial loan, as their expected cash flow will need to be increased to make each payment.
The standard expectation for residential loans is that you will need to make a down payment of 25% of the total price, with the remainder to be paid off throughout your mortgage. Commercial down payments may be higher, and there will often be other limits such as prepayment penalties or lockout periods to prevent the investor from paying ahead of the loan’s maturity.
Whereas years ago people went to local depository banks for residential and even commercial loans, in today’s market there are private money lenders that specialize in either type of loan and solely fund that property type. The larger institutions dominate the market, and while you have options available to you, they may not be the local bank you drive by when commuting to work.
Given these restrictions, you may ask yourself, who can get a commercial loan, and how much can I get? When it comes to residential loans, your income, finances, and credit score are the qualifying factors. But with commercial properties or commercial loans on residential properties, the use of the property makes a difference. For example, will the building be owner-occupied, or will you be renting it out? If the latter, what are the terms of the lease, do they cover property expenses, and to what extent? Ultimately, the lending qualifications are determined by the income the building will generate versus its expense ratio. A building set to generate more income will be eligible for a larger loan than a low-income property.