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Commercial Loans: A Brief Primer

Are you are considering taking out a loan in connection with your business? If so, before you start the process, you should be aware of the differences between personal loans and business loans. This document is designed to give you a brief overview of some of these differences, as well as provide you with some information to help keep your costs down.

Business loans, frequently called commercial loans in the lending industry, are not subject to the same Federal and State regulatory requirements as personal loans are. The difference is particularly evident in the area of mortgage loans. While residential mortgage lenders are required to disclose a loan’s annual percentage rate (or “APR”) and provide a Good Faith Estimate of closing costs and expenses soon after the loan is originated, and to provide the borrower and, where applicable, the seller, at closing a consolidated statement setting forth all of the financial transactions between the parties (referred to as the “HUD-1 Settlement Statement”), commercial lenders are not subject to those requirements. Consequently, it is important to thoroughly investigate the terms of a commercial loan and the related costs before you commit yourself or your company to a commercial loan.

Balloon Payments

As opposed to most residential mortgage loans which are designed to pay the loan amount in full over the term of the loan, the monthly payments in many commercial loans are insufficient to pay the loan in full over the loan term, resulting in a large final payment, referred to as a “balloon payment,” being due at the end of the loan term. Unless the borrower has sufficient cash on hand on the date the final payment is due, it will be necessary to negotiate and close a new loan, whether with the same lender or another lender, and pay all the related costs and expenses.
 
Interest Rates

While most residential mortgage loans have a fixed rate of interest over the full term of the loan, especially since adjustable rate loans fell in disfavor after the secondary mortgage market collapse, the interest rate on most commercial loans adjusts during the term of the loan, frequently every five years. The adjusted interest rate is often based upon a rate of interest which fluctuates with the economy, which can be the rate of interest which the lender offers to its best customers (called its “Prime Rate”), or a rate of interest published by another financial institution or financial publication. This published rate is used as an index to which is added a factor, called a margin, to determine the loan’s adjusted rate of interest. Negotiating the amount of the margin can result in substantial savings over the term of the loan.

Prepayment Charges

Commercial loans commonly include a prepayment charge which is designed to reimburse the lender for interest income which is lost as a result of a loan prepayment and to reimburse the lender for administrative and overhead costs it incurred in closing and administering the loan. Typically, the prepayment charge starts out at 5% of the amount of any prepayment made during the first year, and declines 1% per year until the end of the fifth year. Very often, when the interest rate adjusts, the prepayment charge is reinstituted on the same terms as when the loan originally closed, even though the lender has incurred very little expense to adjust the interest rate. 

If the borrower’s cash flow permits, a loan where the entire loan amount will be paid over the loan term should be considered. If that option is not available or not financially feasible, inquire whether the prepayment charge can be dropped entirely after its initial decline to zero. If these options are not available, a borrower should try to negotiate a reasonable period of time between the date the prepayment charge drops to zero and the date it is reinstituted to permit the loan to be refinanced without incurring a prepayment charge.

If there is a chance that the borrower’s cash flow will permit prepayments from internally generated revenue, as opposed to prepayments resulting from refinancing the loan, an attempt should be made to negotiate an exception to the prepayment charge where the prepayment results from such internally generated revenue.

Negotiating the prepayment charge can be particularly important if there is a possibility that the business will be sold before the end of the loan term. Keep in mind that the sale of the business may result from unexpected circumstances, such as the death or disability of one of the principals (one more reason to adopt a business succession plan). If the lender does not permit the new owners of the business to take over the loan, the borrower will incur a prepayment charge upon the closing of the sale of the business which can result in a substantial reduction in the net proceeds of sale.

Legal Fees

Unlike residential mortgage loans where attorneys typically charge a flat or fixed fee, attorneys’ fees for a commercial loan closing (both the borrower’s own attorney and the lender’s attorneys’ fees which the borrower is required to pay) are based on the attorneys’ hourly rates and the amount of time each attorney devotes to the transaction. Consequently, the attorneys’ fees you pay to close a commercial loan are likely to be affected by how organized and efficient you and your attorney are. In order to expedite the loan origination and closing processes and to attempt to reduce the attorneys’ fees you are required to pay, gather information and documentation your lender and the lender’s attorneys are likely to require before you start. For example, your lender will likely require:
  • Names, addresses and Social Security Numbers for each of the principals of the business and Taxpayer Identification Numbers for a borrower and any guarantor which is not a natural person;
  • Tax returns and financial statements for each borrower and for each shareholder, member and partner of a borrower which is an “entity” (versus a person);
  • Information relating to any assets to be pledged as collateral, such as a description (including model and serial numbers where applicable), location and acquisition cost;
    • If real property is to be pledged as collateral, the original abstract of title (or title search) and survey, copies of the deed, recent tax receipts, rent roll, leases and certificate(s) of occupancy, if available;
  • If the borrower is an entity, copies of its organization documents:
    • For a corporation: Certificate of Incorporation and By-Laws;
    • For a limited liability company: Articles of Organization, Operating Agreement and Certificate of Publication;
    • For a partnership: Partnership Agreement.
In conclusion, commercial loans are very different from the loan you would obtain to purchase or refinance your home. There are no standard loan terms. Each lender offers a different product and the loan terms may be negotiable, depending upon your relationship with the lender, the amount of the loan, and the value of the property the borrower can offer the lender as security for repayment of the loan. We have extensive experience handling commercial loan transactions for purchasers, sellers, borrowers and lenders and bring that valuable experience to bear when guiding clients through the complexities of a commercial loan transaction.