Everything You Need to Know About Commercial Loans

Commercial loans are everywhere, yet their intricacies are often unaccounted for by the average investor. This is largely due to the fact that most individual investors have never invested in commercial loans.

Thanks to digital platforms like Heron Finance, many accredited investors are now discovering the benefits of investing in this growing sector of the market.

In this article, we’ll uncover the commercial lending industry by exploring the common types and key characteristics of commercial loans, how lenders price such loans, how commercial loans differ from their consumer loan counterparts, and the benefits and risks to those looking to invest in this sector of the market.

Key Highlights

• Businesses rely on commercial loans to finance their ongoing operations or capex
• Lenders consider many factors when pricing commercial loans, including their costs in originating and underwriting the loan, the risk premium and necessary profit margin
• Investing in commercial loans carries numerous benefits for investors looking to diversify away from traditional stocks and bonds. Such investments also carry risks, which can be mitigated by digital platforms like Heron Finance

What is a Commercial Loan?

A commercial loan is a debt-based funding arrangement between a business and a financial institution (usually a bank or private credit lender). Commercial loans are typically used to fund major capital expenditures or cover operational costs that the company might otherwise be unable to afford.^[1]

Key characteristics of commercial loans include:

• They are granted to a variety of business entities, usually to assist with short-term funding needs
• Collateral is often required, such as property, equipment, or future accounts receivable
• Businesses typically must provide financial statements to prove their ability to repay
• For variable rate loans, interest rates are often aligned with the prime lending rate at the time the loan is issued
• Repayment terms can range from several months to many years (even decades), depending on the lender and loan type

Common types of commercial loans include:^[2]

• Working capital loans for temporary funding of seasonal needs
• Term loans for acquiring capital assets like equipment or real estate
• Commercial mortgages for financing commercial property
• Acquisition loans for businesses buying other companies or divisions

While most commercial loans are short-term, they can often be "rolled" or renewed to extend the life of the loan.^[3] This allows businesses to maintain ongoing operations while repaying the initial loan within its specified term

How Do Lenders Price Commercial Loans?

Lenders consider various components when pricing commercial loans:^[4]

• Cost of funds: The bank's cost of obtaining the capital to lend, which includes the interest paid on deposits and other funding sources
• Operating costs: The expenses associated with originating, underwriting, and servicing the loan, such as staffing, technology, and facilities costs
• Risk premium: An additional charge to compensate the bank for the credit risk of the borrower defaulting. Riskier loans require a higher premium
• Profit margin: The desired return on the bank's capital allocated to the loan, often expressed as a target yield or return on equity

Lenders also consider factors like the loan type, collateral, repayment terms, and the borrower's creditworthiness when setting the interest rate. Rates are typically higher for loans with lower LTV ratios, shorter terms, and weaker borrowers (those more likely to default).

Some lenders use loan pricing models that incorporate these components to calculate a risk-adjusted return for each loan. Ultimately, the goal is to price the loan at a level that covers the lender’s costs, compensates for risk, and provides an acceptable profit margin. Rates are often benchmarked to indices like the prime rate or Treasury yields, with an added spread to account for the lender’s costs and profit.^[5]

What are the Differences Between Commercial and Consumer Loans?

The most obvious difference between commercial and consumer loans is who uses them; businesses use the former, while individuals use the latter. Yet there are other differentiating factors that one should be aware of:

• Loan Types: Common commercial loans include term loans, lines of credit, commercial mortgages, and accounts receivable financing. Consumer loans include personal loans, mortgages, auto loans, student loans, and credit cards.
• Collateral and Guarantees: Commercial loans often require collateral such as business assets, real estate, or personal guarantees from the business owners. Consumer loans may require collateral like a home or vehicle, but personal guarantees are less common.
• Interest Rates and Terms: Commercial loans typically have higher interest rates and shorter repayment periods compared to consumer loans.
• Documentation and Underwriting: Qualifying for a commercial loan requires extensive documentation on the business's financials, collateral, and the purpose of the loan. Consumer loans have a simpler application process focused more on the individual's credit history and ability to repay,
• Lender Type: Commercial loans are more likely to come from local banks that specialize in business lending, while consumer loans are available from a wider range of national lenders.

What are the Benefits and Risks of Investing in Commercial Loans?

The main benefits of investing in commercial loans include:

• Higher potential returns compared to other fixed-income investments, with the potential for annualized double-digit yields (Heron Finance offers a target APY of 10-14%, net of all fees).
• Diversification of an investment portfolio by adding an asset class that is less correlated with stocks and bonds.
• The ability to participate in the types of investments once reserved for institutions and the ultra wealthy with a relatively small amount of capital, thanks to the advent of digital platforms that grant access to commercial lending investments.

The primary risks of investing in commercial loans include:

• The potential for a loss of capital should borrowers fail to repay the principal and default on the loan agreement.
• A lack of liquidity, as commercial lending is an inherently illiquid asset class. Digital platforms like Heron Finance are working hard to change this–read our approach to liquidity to learn more.
• Interest rate and inflation risk. Should macroeconomic conditions change, a shift in interest rates or inflation could upend the expected returns for investors (yet it’s also worth noting that the commercial lending industry tends to fare better during times of higher interest rates, since most commercial loans are floating rate, hence the yield repayments increase as interest rates rise).^[6]

While no investment comes without risk, Heron Finance is working hard to mitigate the risks that come with investing in commercial loans. For example, we select lending partners with an extensive track record of success in commercial lending–our partners maintain loss ratios ranging from 0% to 1.3%.

We also ensure that our portfolios are diversified across industry and geography, protecting investors from an exogenous event that negatively impacts a single industry or location.

For more information on how we select deals to invest in, read our deep dive here.

And to start investing in commercial loans, simply click the button below to create your Heron Finance account. Our platform will build you a diversified portfolio of commercial loans, and automatically rebalance that portfolio over time, making the investment process as seamless and hassle-free as possible.