What Are Commercial Loans and How They Work?

Mar 18, 2022

5

min read

T

he primary source of business is equity and retained earnings. But, sometimes, the company needs to take out loans to meet the shortfall of money.

There are various reasons why businesses take out loans, such as to meet short-term liquidation problems or to expand the business.

But, since commercial loans are different from personal loans, there are various things to consider before applying for commercial loans. Understanding the commercial loan better is essential to get the best out of it.

The article covers everything on commercial loans.

What Are Commercial Loans?

Commercial loans or business loans are debt financing instruments for the business to meet its short-term and long-term capital needs.

While the business funds its capital needs through equity, it is unfeasible for the business to access the equity and bond market every time to meet the financial requirements. In such cases, the companies borrow commercial loans.

Commercial loans may be used to acquire assets, purchase supplies, meet daily operations expenditures, pay wages, and other company needs.

How Do Commercial Loans Work?

The business applies for the commercial loan to the lenders, and when approved, the company receives a lump sum of money or a credit line. Upon borrowing the loan, the business has to pay interest to the lenders.

However, unlike other loans, commercial loans are often unsecured and uncollateralized. This implies that no collateral or security is required while borrowing commercial loans.

But, in the unsecured loan, the borrowers need to sign a personal guarantor who agrees to repay the loan if the business fails to repay the loan.

However, there are secured commercial loans where the company may use inventory or accounts receivable as collateral. Since the commercial loan is usually a short-term loan, the company's credit history and debt - to income ratio of the company play a huge role in the loan approval.

Types Of Commercial Loans

Commercial loans can be broadly classified as: Short-term and Long-term commercial loans. Usually, commercial loans for less than a year are short-term commercial loans, whereas any loan beyond one year is known as a long-term commercial loan.

However, there are several types of commercial loans within these categories. Some of them are as follows :

Working Capital Loans

Working capital loans are used to fund a company's short-term capital requirements for day-to-day operations.

For example, they're often utilized to buy raw materials, hire additional workers, purchase equipment, and other operational expenditures during the holiday season.

They are short-term business loans to fund short-term financial obligations and operational requirements. The company usually repays the loan through inventory sales or cash receivable.

Real Estate Loans

Real estate loans are used to finance the acquisition and investment in real estate. They are long-term loans and are suitable for both residential and commercial buildings.

These commercial loans are used to buy residential homes, commercial buildings, and land property for the business. These loans are borrowed either for investment purposes or residential purposes.

For example, the business may borrow a real estate loan to build the head office.

Business Line of Credit

A business line of credit is a commercial loan similar to a credit card. In this loan, the business is eligible for a specific limit of money which can be used as required. The best part of this loan is that the company only pays interest on the amount utilized.

A line of credit is ideal for firms that need cash regularly to finance operational expenditures. In addition, it is a great way to deal with a liquidity crisis.

For example, the jacket company has no sales in summer but still has to pay their employees. In such a case, they can borrow a business line of credit to pay the employees' salaries.

Bridge Loans

Bridge loans are used to bridge the gap between what a company needs right now and a longer-term funding option. These loans have higher interest rates than permanent loans, but they help firms fulfill urgent commitments by providing temporary cash flow.

For instance, the company plans to sell one of its properties to purchase a new property on urgent sale. But, since selling the property takes time, the company does not have any instant cash or money to buy the property.

In such cases, bridge loans come into play as it helps to fund the company until it has the cash flow it needs.

Inventory Financing

Businesses need to purchase raw materials to make products and sell the goods in the market. However, the cost of the raw materials is the production cost which incurs before the sales. The company borrows inventory financing to meet the raw materials requirements in such cases.

Inventory finance is intended to assist in the payment of these upfront expenses. In addition, the inventory serves as security for the loan.

For instance, The clothing line company may buy materials in bulk upfront. Then, the business borrows the loan with the raw materials as the security. Finally, it pays back the loan when the final product is ready and is sold in the market.

Accounts Receivable Financing

A company's accounts receivables are used as collateral to borrow working capital in accounts receivable financing. This helps the company meet its liquidation crisis by converting the future cash flow to the present one.

This sort of financing is ideal for companies with many invoices to pay and can't wait for them to be paid before using the money.

For example, Some companies open pre-booking for the products they have not yet produced. The companies use pre-booking to finance the production of the goods.

Requirements For Commercial Loan

Good credit score
Low debt to income ratio
Property cash flow
Documented property value
Income and assets of the guarantor

How To Choose A Commercial Loan Lender?

Choosing the best commercial loan lenders that meet your loan requirements and needs is crucial.

Because commercial loans are very risky, there is a high chance of your loan application getting rejected if you don't apply for a loan in the bank that meets your needs and requirements.

Thus, it would be best to go through a pool of lenders to know what they are offering and whether it meets your requirements. It is advisable to choose flexible lenders, have high approval rates, and have speedy service.

Getting a business loan can be a hassle if you don't choose a lender who is best for you. Here are some of our top lender suggestions for commercial loans:

Charlotte Metro Credit Union

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