Difference Between a Consumer Mortgage Loan and a Commercial Real Estate Loan

Mortgage
August 19, 2021

Many new property investors and eager business owners apply for commercial property loans, thinking that the application and approval process is the same as that of home loans. This is not true.

There are many notable differences between consumer mortgages and commercial mortgages-and it’s best to be aware of these differences before you decide on a loan to support your investment efforts or your growing business.

Uses

The biggest difference between commercial real estate loans and consumer mortgages is how you can use them.

Home loans are designed to help borrowers finance the purchase of a residence. Commercial mortgages, on the other hand, are intended for investors and business owners who want to purchase commercial premises, including the following:

  • Industrial buildings
  • Warehouses
  • Hotels
  • Restaurants
  • Shopping and retail centers
  • Apartment buildings with five or more units (anything smaller can be financed with a home mortgage)

Interest rates

Consumer mortgage interest rates are typically lower than interest rates imposed on commercial property loans, where rates depend on the term of the loan and the amount borrowed, among many other factors.

Another difference is that residential loans usually have fixed interest rates. You can lock in a rate so that your monthly payments stay the same no matter what happens to the market.

Commercial mortgages, on the other hand, typically have variable interest rates. Your loan rate will be tied to a standard index and will go up and down as that index fluctuates. This variability—along with a shorter amortization period—lowers the lender’s risk because your mortgage payment will go up should interest rates skyrocket in the future.

Amortization period

This refers to the length of the loan. Residential mortgages are usually longer-term and commercial mortgages are generally much shorter. Most commercial real estate loans range from 3 to 10 years; in fact, 10-year commercial property loans are rare.

Because lenders take a lower amount of risk with residential mortgages, repayment periods are more flexible. They can be as long as 50 years or short as 15 years. In addition, you can usually pay your mortgage payments in advance if you wish to.

It’s possible to negotiate repayment periods in commercial loans, but the maximum term is ten years. The shorter term of commercial mortgages means less risk for lenders because they get higher amounts of payment every month.

However, there’s also less flexibility when it comes to prepayment. You might be slapped with a prepayment penalty for paying the loan off too early.

Collateral

Your home is your collateral when you apply for a consumer mortgage—which means that the bank will take it if you’re unable to pay your loan for some reason or another. So your collateral is essentially the lender’s insurance should you fail to make good on your payments.

The collateral depends on your qualifications and the lender’s requirements for commercial real estate loans, but it can be ‘anything of value.’ Some lenders will accept stocks and bonds, among other assets.

Hard money lenders usually only need the property as the collateral, which means that they will take possession of the commercial property and do what they want with it (probably sell it) should you fail to pay back your loan.

Amount of risk

Risk is another primary factor that separates these two types of mortgages. Residential mortgages are generally considered less risky compared to commercial mortgage loans. This is because, in a home loan, banks base their lending decision on your income.

Therefore, they will look at how much you make to ensure that you have enough money coming in to make your monthly payments comfortably. Ideally, your monthly mortgage payments should not be more than 28% of your gross monthly income.

Commercial mortgages are different because, as the borrower, you will mainly use the income from the property or from your business to pay the loan back. Instead of basing their decision on your annual salary, the commercial mortgage lender has to look closely at your business and predict whether or not it will succeed.

This makes commercial mortgages a riskier option. Lenders will typically require a debt coverage ratio of 1.25—meaning you have to earn at least 25% more than your commercial mortgage payments.

Down payment size

It’s possible to negotiate with the bank about the down payment size on a home mortgage, but lenders are generally stricter about down payment requirements for commercial mortgages.

Commercial loan down payments are also higher—usually at least 20%. However, some lenders will allow certain buyers to pay just a 10% down payment on rare occasions. Again, it’s important to have a seasoned relationship with a commercial mortgage lender if you want to negotiate this number.

Lending criteria

Your income is the primary indicator of whether or not you qualify for a residential loan. But with commercial mortgages, it’s mainly about the property and the income it generates. The more profitable a property is, the less critical your income becomes in the eyes of the lender.

Commercial property loans are generally much larger, so lenders require more complex information than they would when underwriting a residential mortgage.

Make sure that you’re aware of the specific requirements of the commercial mortgage provider you want to work with. Offers for larger commercial property loans are typically bespoke.

If you are not satisfied with the offer, it’s possible to negotiate interest margins, fees, and the security offered. You may also be able to negotiate payment terms if you have successfully worked with the lender before.

Regulations

Residential mortgages are regulated by the Federal Trade Commission, the Consumer Financial Protection Bureau, and the Department of Housing and Urban Development. Commercial mortgages are less regulated and are mainly considered as purely commercial transactions.

Pricing

Home mortgage pricing is typically lower because there is more competition in the market. The risk-weighting is also lower for home loan lenders, which means they are required to set aside less cash.

Commercial mortgage pricing is higher compared to residential mortgages because of the risk involved. In addition, commercial property loan lenders are required to set aside more money because risk-weighting regulations are much stricter.

Process

When applying for a consumer mortgage loan, you generally have to go through the following steps:

  • Prequalification
  • Application
  • Home inspection
  • Buying homeowners insurance
  • Locking in your interest rate
  • Reviewing the documents
  • Arranging closing costs and down payment
  • Moving into your new home

The commercial mortgage loan process requires more documentation and is significantly more involved.

  • Prequalification
  • Loan application
  • Providing collateral (may include real estate, stocks, and bonds)
  • Receiving and reviewing of letter of intent/term sheet from the lender
  • Waiting for loan approval (additional documents may be required during this stage)
  • Resubmission of the loan application package to the loan committee
  • Final approval
  • The signing of the finalized commercial mortgage documents

The commercial loan application process is faster if you work with hard money and bridge loan lenders instead of traditional banks. These alternative financing sources may be the best option for specific projects, particularly fix-and-flip properties. They can also give you the funding you need while you wait to get traditional financing.

While we’ve discussed the main differences between home loans and commercial property loans, this is not a complete and exhaustive list. Therefore, it’s important to talk to a commercial property mortgage specialist for expert guidance.

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