Loans are the primary debt instruments through which individuals and businesses raise money for their projects. Considering the large initial seed capital required to finance large-scale projects, businesses have no option other than opting for commercial loans from banks, unless they have angel investors or venture capitalists, backing them up. In this Buzzle article, I provide you with an explanation of what are commercial loans and how they work, in a nutshell.
What are Commercial Loans?
A loan is an amount of money lent at a fixed interest rate by a bank or any financial institution to an individual or business in need of financing. The borrower or borrowing institution can then return the principal with interest through monthly installments. Commercial loans are loans granted to businesses in search of funding, to either expand their existing operations or start a new one. There may be various other reasons, that might prompt a business to apply for a loan.
One thing that distinguishes commercial loans from personal loans is their need for collateral. That's because commercial loans are secured loans and banks need means to recover their invested principal amount, in case the borrower fails to repay.
These are primarily big sum loans, with repayment period spread over a number of years and fixed or variable interest rates. Construction loans are one of the primary examples of commercial loans.
Working of the Commercial Loaning System
A business shopping around for a commercial loan will review and compare the interest rates offered by banks and financial institutions. A couple of banks with the most conducive interest rates are shortlisted and formally approached with a loan application. The application includes a business plan which details the way in which the loan amount will be utilized. Information about the collateral that the business offers as loan security is also provided. This may be a land or commercial property. On the basis of the collateral offered and the performance potential of the business, the bank can decide the amount of loan it can sanction.
During the scrutiny of a commercial loan application, banks primarily check out the credit history and past performance of the business. The proposed business model is also studied by bank officials to determine the future earning potential of the business. If the business fares well in the bank's overall scrutiny of their financial record, a loan proposal is provided by the bank to the business, detailing the legal conditions involved, amount of loan sanctioned and the interest rate charged.
The interest rate charged is typically higher than personal loans and the mode of repayment is quite flexible. Interest rate is also dependent on repayment period. Once sanctioned, the loan amount is credited in the business account after ownership documents of the collateral property are submitted to the bank as security. For small commercial loans, a collateral may not be required. The repayment schedule comes into effect immediately after the loan's sanctioned. As and when the business repays the loans with interest, over a period of a few years, the collateral assets pledged as security are handed over back to the business. In the event of the borrower failing to repay a loan, lender holds the right to sell off the collateral to recover his money.
To sum up everything, the procedure for sanctioning of commercial loans is similar to personal loans, with the only difference being that the credit history of the business is evaluated, instead of individual credit history. Considering the fact that these loans involve large amounts of money, commercial loans are mostly mortgage loans with a land or real estate property as collateral. In return for a sizable collateral, the bank lends a commercial loan at fixed or floating interest rate, which the business must pay back in installments, spread over a few years.