Investments can be tricky, and if you are looking into making more money in real estate, keep in mind that loans may appear the same, but they are not. Before venturing into commercial or residential real estate, there are a few things that you will need to consider, from different interest rates, loan terms, amortization periods, and penalties. Banks will also look into the types of income you have and if the real estate property generated revenue.
Interest Rates
Commercial real estate or CRE and residential loans have different interest rates; CRE are considered at a higher risk, therefore, are required to pay more than residential loans. Commercial interest rates will go up or down depending on the standard index. On the other hand, residential interest loans usually have a fixed rate, depending on the term. Additionally, the index for interest rates tied to CRE loans is typically different then residential loans, and do not have as much volatility in rate changes.
Down Payments
Both residential and commercial loans will require a down payment. For residential loans, it can be as low as 3-5% of the loan. Commercial loans require more, with minimum down payments depending on the asset class typically starting at 25%, but many types of assets start at a minimum of 35% down.
Amortization Periods and Loan Terms
Since the risks are higher for commercial real estate loans, their loan term is also made shorter. They typically have a “due in ten year” clause, with amortizations between 15-25 years. Residential loans; however, will typically have longer amortization schedules and full amortizing terms (30 years, some even 40 year amortizations), which allows the lender a working capital during the duration of the amortization period.
Commercial Real Estate Loan Penalties
Unlike residential loans, commercial real estate loans are designed differently to lower the lender's risks and to protect the lender's yield on the loan. The payment penalties are intended like a sliding scale wherein the percentage of the loan decreases per year. Additionally, some commercial loans may have a “Yield Maintenance” clause, which means that if you refinance or sell the property prior to the loan coming due, you may owe the lender all of the interest that they would have earned for the full term of the loan.
Types of Income
Lenders will be looking out for different kinds of income for both types of loans. For commercial real estate loans, leaders will look into your DCR or the debt coverage ratio, and this refers to your property's ability to generate income to pay off your loan (typically commercial lenders look for the net operating income to be at least 1.20 times the debt service). For residential loans, they will first look at the lender's debt-to-income ratio. These will include debt that is not more than 45% of your gross income. Second, your mortgage payment dues should not exceed more than 28% of your monthly gross income.
Government Oversight
There are much more protections to the end consumer on residential loans, with all residential loans falling under the RESPA guidelines. This is not the case for commercial loans, where everything may be negotiated, for the terms, interest rate, event the loan docs. It is always advised to engage a good attorney that can review the commercial loan docs prior to signing.