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So you’ve done your homework and decided on real estate as your next investment. You’re still scouting for potential properties, but you know at the least you’ll be financing your purchase to maximize your cashflow. One question remains, however: will you be taking out a residential or commercial loan? This article will compare residential and commercial lending options and look at a couple different scenarios to illustrate the major differences.
Residential Real Estate Loans
Generally simpler to draw up, residential real estate loans are the most common form of real estate lending. Since mortgages on a primary residence fall into this group, this is often the first type of home financing a novice investor will encounter. The length of the loan is the same as the traditional mortgage – 15 or 30 years. Note that it’s generally advisable to take the 30-year option to lower monthly mortgage payments and increase cashflow. Unlike a primary residence, an investment property will require a larger down payment – usually 25%. Residential loans are popular for solo first-time investors because the loan-to-value ratio (how much money the bank will give you relative to what the property is worth) is higher than a commercial loan’s and you don’t need to register a business to apply. The bank will take a close look at your credit history and personal income before approval. But, assuming the investor is in good financial standing, a residential loan can be a an excellent, low-risk first step into the world of real-estate investing.
Commercial Real Estate Loans
Contrary to what one might assume, commercial loans can be used for residential properties. You could, hypothetically, use a commercial loan to finance a single-family home if you wanted to. Any income-producing property can be considered a commercial space. While this is also a viable option for investors, there are some factors to take into consideration when getting a commercial loan. First, the interest rates and fees are usually higher on commercial loans. However, the loan terms are typically shorter, usually between 1 and 5 years although, many commercial lenders now offer 15 and 30 year loans. With shorter loans terms, borrowers will have to deal with higher monthly payments relative to a residential loan. What’s more, longer term commercial loans can be less flexible when it comes to payment schedule. A 30-year residential loan can be paid off in 15 years without much issue. On the other hand, commercial lenders incur higher risk, and want to avoid large fluctuations in their cash flow over the long term. To this end, commercial loans usually have prepayment penalties in place to discourage borrowers from paying their balance off earlier than planned.
So, what are the advantages of a commercial loan? Well, for one, commercial loans are made to business entities, not individuals. LLCs, corporations, partnerships, and trusts are all examples of businesses that can apply for commercial lending. Borrowing money as a commercial entity can confer several advantages. Most significantly, a business entity is able to lease a space to another business. One example would be a retail holding company leasing store space to a clothing shop.
Operating as a business brings multiple tax and legal benefits, and can be useful to protect owners from loan default or legal action. In some states, a bank may have the legal right to go after a borrower’s personal assets if they default on their property payments. There are other reasons why a commercial may make more sense. Commercial lending tends to be a more specialized field, with companies specializing in, say, warehouse spaces and warehouse spaces alone. Depending on the property in your sights, it may make more sense to seek out a lender with financial and legal experience specific to property you want to acquire.
If you have any questions about which type of loan if right for you, the experts at RCN Capital would be more than happy to have a conversation. Contact us today!