Let us be the first to say that there is a substantial amount of financial jargon and regurgitation that circulates in almost every facet of our lives. (Arguably, too much.)
So, in order to bridge the gap between what we know as banking professionals and what you should know as consumers, small business owners, and real estate investors, we're providing a glossary of commercial loan terminology to set you and your businesses endeavors up for success.
Don't say we never gave you anything.
Assets
Your assets come into play during the loan application process and influence the type of loan you qualify for, and the interest rates you can receive. Two common categories they can fall under are:
- Fixed Assets: long-term tangible pieces of property or equipment that you plan to use long-term to help generate income.
- Current assets: items expected to be converted to cash or used within the year such as accounts receivable, stock inventory, bank accounts, and prepaid expenses.
Amortization Period
The amortization period is the total length of time it will take to pay off a loan — which depending on the loan size could be anywhere from a couple of months, to 25 years. A longer amortization period means lower monthly payments but higher interest costs. On the contrary, a shorter amortization period means higher monthly payments but less overall interest accrual.
Balloon Payment
A balloon payment is a larger one-time payment due at the end of the loan term as your final installment. This comes as the result of having lower monthly payments throughout the amortization period, and then owing the remaining balance at the maturity date.
Side note: A refinance can help deflate your balloon payment.
Basis Points
1 Basis Point = 1/100th of a percent
Basis points are just another way of describing the interest rate on a loan. For example, 375 basis points equals a 3.75% interest rate. Do not be thrown off if you also hear them referred to as "bips".
Cap Rate
Cap rate, known formally as the "capitalization rate", is one way of estimating a property's income generating potential.
How to calculate: Net Operating Income ÷ Purchase Price = Cap Rate (%)
Credit Line
A business line of credit is a commercial loan option best for small business owners tackling small renovation projects over extended periods of time. Think of it as a revolving sum of money that is replenished every time you pay down your balance. You get to withdrawal money as you need and only pay interest on the money you use.
DSCR
The debt service coverage ratio is the measure of a property or business' cash flow in comparison to its current debt obligations. It is used during the application process by lenders who want to see if property or business has enough income to pay off its debts before taking on any new debt.
How to calculate: Net Operating Income ÷ Total Debt Service = DSCR
Exit Fee
When discussing commercial loan terminology and commercial loan terms, "exit fee" is bound to come up in conversation. An exit fee is a one-time payoff due when paying off the loan in full, either when prepaying or at maturity date. Depending on your loan terms, an exit fee allows for lower interest rates and no upfront payment.
Hard Costs vs. Soft Costs
Costs associated with physical aspects of a commercial real estate deal such as construction costs, materials, and labor are categorized as hard costs. Fees not directly related to labor and building materials — delivery, permits, insurance, etc. — are soft costs. Both can be covered in certain loan agreements.
Lien
Lien is a claim against assets — like real estate or equipment — and serves as a guarantee on repayment of a loan. That means the lender has the legal right to seize and sell the property or equipment that was used to secure the loan, in order to satisfy the debt.
Liquidity
Liquidity refers to the ease with which an asset can be converted into ready cash WITHOUT affecting its market price. Cash is the most liquid of assets, while tangible items — real estate and equipment — are less so.
Loan-to-Cost Ratio
The loan-to-cost (LTC) ratio is used to analyze the risk of commercial real estate projects. It compares the loan amount to the construction cost to get you a (hopefully) lower percentage. The higher the percentage, the riskier the project for lenders to finance. Luckily, in addition to the LTC, lenders will take into account the location and value of the property on which the project is being built, the builder credentials, the borrower's credit history, and the loan-to-value ration when deciding to issue a construction loan.
Loan to Value Ratio
The loan-to-value (LTV) ratio compares the loan amount to the expected market value of the completed project.
Maturity Date
The date the loan is due.
Net Operating Income (NOI)
The NOI measures the profitability of a property. It is used by lenders and borrowers alike: 1). to determine if the borrower is worth the risk and 2.) if the property is worth the expense of owning and maintaining it.
How to calculate: Revenue — Operating Expenses = Net Operating Income
Principal
Principal is used to describe both the initial size of the loan (pre-interest) and the amount still owed after payments. For example If you take out a $75,000 commercial loan, the principal is $75,000. If you pay off $25,000, the principal is now the remaining balance of $50,000.
Not confusing at all...
Refinance
Refinancing a commercial loan means replacing the original loan with a new one, usually to save money in the long-run whether that be through more favorable loan terms, debt consolidation, or property investments.
If you're wondering whether a refinance may be right for you, check out our Guide to Commercial Loan Refinancing.
SBA
The Small Business Administration (SBA) is a government-backed agency that offers resources and funding for small businesses in the U.S. Their two most popular loan programs — and where you'll hear the term SBA thrown around the most — are the 504 and 7(a), which can be used for any business need including buying real estate, constructing a building, leasing equipment, or taking on renovation projects of all sizes.
Secured vs. Unsecured Loan
A secured loan requires borrowers to offer collateral in order to receive financing; whereas an unsecured loan does not. The route you choose affects loan interest rates, borrow amount, and repayment terms.
Self-Funded Search Fund
A self-funded search fund — redundant, I know — is a business acquisition method growing in popularity amongst younger generations. Instead of recruiting investors and securing financing before finding a company to acquire, an entrepreneur looks for a business without financial backing and seeks funding once they've found their business. It’s an effective way for young business leaders to find small to medium-sized businesses to acquire, grow, and ultimately sell to achieve a return to their equity investors.
Underwriting
Underwriting is the process lenders use to evaluate potential customers. They will look at different personal and business credentials including credit score, revenue, income, and assets to decide if you and/or your business is worth the risk of lending to. When it comes to commercial real estate underwriting, they will also consider the cap rates, vacancy rates, rent and expense growth, and the capital expenditures reserves.
Now that you understand the commercial loan terminology, are you ready to take the next step towards applying? Prepare with Security's Commercial Loan Application Checklist and talk to one of our experienced lenders today.
