Commercial loan amortization is the process of spreading out a loan into a series of fixed payments over time. You’ll often see amortization referred to in relation to home mortgage loans, but it’s also used for commercial real estate loans. Whether you’re a business owner looking to take out a loan for a new property, or you’re a lender considering providing financing, it’s important to understand how amortization works.
What Is Commercial Loan Amortization and How Does It Work?
Amortization is the process of gradually paying off a commercial mortgage or loan through periodic payments. This involves the borrower making payments for the commercial property that pay down both the loan principal and interest. As a result, the amount of each payment that goes toward the principal gradually increases while the amount going toward interest decreases.
For commercial real estate loans, amortization typically occurs over a span of 25 years at most. The specific term, however, will vary depending on the loan agreement. Amortization schedules can be set up so that payments are made on a monthly, quarterly, semi-annual, or annual basis.
The amortization schedule for a business loan or other form of a commercial loan can be found in the promissory note signed at the time of closing. In general, the schedule should outline the required monthly payments, as well as when those payments are due.
Before extending a commercial real estate loan, a lender may determine eligibility by a few factors. First, the lender will check the borrower’s personal credit score and business credit score. Then, they’ll evaluate the size of your down payment and the debt-service coverage ratio (DSCR), which is a financial ratio that measures the ability of a borrower to make loan payments. The ratio is calculated by dividing the property’s net operating income (NOI) by its total annual debt service.
A lower DSCR indicates that a property is less able to generate income to cover its debt obligations. On the other hand, a higher DSCR indicates that a property is more able to generate income to cover its debt obligations. The DSCR can affect the outcome of a loan application more than just about any other metric.
Commercial Mortgage Calculators
To calculate amortization on a commercial real estate loan, borrowers can use an online amortization calculator or set up their own spreadsheet. The borrower will need to input information into the loan calculator, such as the loan amount, interest rate, and term length, to generate a schedule of payments, showing how much of each payment will go towards principal and interest.
For example, consider a $1,000,000 property loan on an investment property with a six percent rate and a 20-year term. This would result in monthly payments of $7,164.31, with 42 percent of total payments going toward interest, and 58 percent paying down the principal.
Borrowers should keep in mind that amortization is just one factor to consider when taking out a commercial real estate loan. Other important factors include the loan’s interest rate, terms, and fees. It is recommended that a borrower compares offers from multiple lenders before selecting a loan.
What Are the Advantages of Amortizing a Commercial Loan?
One of the benefits of amortization is that it can help reduce the amount of interest you pay on your loan. When you make fixed monthly payments, a portion of each payment goes towards paying down not only the total interest but the principal balance of your loan.
Plus, interest payments are often tax deductible, which can provide some financial relief when it’s time to file tax returns. Amortization also allows you to build equity in your commercial or personal property over time. As your loan balance decreases, your equity increases. This can be beneficial if you ever need to work on refinancing or selling your property.
Additionally, amortizing a commercial or personal loan allows for predictability in your business plan. Business owners or individuals can know exactly how much they need to set aside each month in order to make their loan payments, which makes it easier to manage cash flow. And because the interest is paid down over time, the monthly payments on an amortized loan tend to decrease as the loan matures.
What Are the Drawbacks of Commercial Loan Amortization?
As with any financial product, there are potential downsides to commercial loan amortization. One drawback is that it can take a long time to pay off the entire balance of the loan if it has a longer repayment schedule. Because each payment goes towards both principal and interest, the borrower may end up paying more in interest over the life of the loan than if they had made higher monthly payments with a higher mortgage rate.
What Are Alternatives to Amortization?
There are a few alternatives to amortization when it comes to commercial real estate loans. One option is to finance the loan with interest-only payments. This means that you would only be required to pay the interest on the loan each month, and the principal would not be amortized.
This can be a good option if you are expecting to sell the property or refinance within a few years and want to keep your monthly payments low. Another alternative is to get a balloon payment mortgage, which involves making lower monthly payments for a certain period of time.
Then the borrower has to pay off the entire remaining balance of the loan in one lump-sum mortgage payment (the “balloon”) at the end of that period. This approach can be risky since you are counting on being able to sell the property or refinance before that final payment comes due.
It could also be a good way to keep your monthly payment amounts low if you know you’ll have the money available when that final payment comes due. A third alternative is to get an adjustable-rate mortgage (ARM). With an ARM, your interest loan rate may fluctuate over time, so your monthly payments may go up or down depending on market conditions.
ARMs are potentially riskier than fixed-rate loans, but they may also offer lower interest rates and monthly payments initially. Deciding which of these alternatives is best for you will depend on your individual circumstances and goals. Talk to your lender about all of your options.
How To Choose the Right Commercial Loan Amortization Plan
There are a few considerations to take into account when choosing the right commercial loan amortization plan for your real estate investment. The first is the length of time you plan on holding the property. If you plan on selling the property in a few years, then a shorter amortization period may be best.
On the other hand, if you plan on holding the property for many years, then a longer amortization period may be more beneficial. Consider your cash flow as well. A more extensive amortization term will typically have lower monthly payments, which can free up working capital for other types of investments.
Keep in mind that you’ll ultimately pay more interest over the life of the loan with a longer amortization loan term. Lastly, consider your exit strategy. If you think there’s a chance you may need to sell the property before the loan is paid off, then it could be a good idea to choose an amortization schedule that won’t leave you with a large balloon payment at the end.
Bottom Line on Commercial Loan Amortization
Amortization is the process of gradually reducing a loan balance through periodic payments. The amortization schedule is an important factor to consider when taking out a commercial real estate loan since it can have a significant impact on your loan payments. Other key takeaways about commercial loan amortization:
- Most of the different types of commercial loans, such as SBA loans and construction loans are typically amortized over a period of up to 25 years.
- Amortization can have tax implications, as interest is tax-deductible.
- It can affect the cash flow of a property, as periodic payments may be higher or lower depending on the annual interest rate and term of the loan.
- Use an amortization calculator to see how your payments will be allocated over the life of the loan and make sure that you are prepared to pay on time.
- Alternatives to an amortization plan include interest-only payments, a balloon payment mortgage, and an adjustable-rate mortgage (ARM).
It is recommended that borrowers consult with their accountant or tax advisor to determine how amortization will affect their specific situation. Understanding how amortization works is crucial when taking out a commercial loan so you can make the best decision that aligns with your financial goals.
