CRE Loans: Understanding Loan Term vs Amortization
In commercial real estate, everything from the sale to the mortgage tends to be more complex than in the residential market. Often, in meeting a borrower’s unique needs, these loans offer additional nuances and options.
What is the difference between loan term and amortization? What is the amortization period of a loan? The loan’s amortization period and term for commercial real estate mortgages can be confused for one another but are just some of the unique options integrated within the sale.
In this article, we’ll take a closer look at loan term vs amortization to gain a better understanding of both and, ultimately, commercial real estate mortgages as a whole.
Understanding Loan Terms
The period of time the borrower must repay the loan’s principal balance is known as its term. Generally, most commercial real estate loans tend to range from 5-10 years, although they can range up to a longer term of 30 years.
Typically, the 5-10 year length of time is enough for borrowers to execute their business plan for the property while providing lenders with a relatively short-term commitment.
What Determines a Loan Term?
The loan term can vary dramatically depending on the situation but is primarily influenced by two significant factors in the sale.
The Bank’s Willingness to Commit
The lender might or might not be willing to take on a loan transaction commitment for the long term depending on the banking institution’s view of movements in interest rates and macroeconomic conditions. Because of this, the duration of the commitment the bank is willing to partake in the transaction is often a significant consideration in the loan term.
The Specific Needs of the Sale
The transaction’s specific needs will vary from borrower to borrower, impacting the loan term. For example, the loan may have a shorter duration than one intended to be held for an extended period if a borrower wants to purchase a property, renovate it, and lease it up to stabilization in a short amount of time.
Understanding Loan Amortization
The amount of time you calculate the loan’s payments is better known as the loan’s amortization period. It is common in commercial real estate for the loan’s term and amortization periods to differ, also known as split amortizations.
Similar to a loan’s term, an amortization period varies drastically from one transaction to the next. You can determine the loan amortization period on a basis needed to accommodate the specific needs of the commercial real estate sale. Typically, a commercial real estate loan amortization period is between 20-30 years.
What Are Split Amortizations?
An example of split amortization would be a loan with a 5-year term with payments based on a 30-year amortization schedule.
To minimize the amount of cash needed upfront for purchasing commercial real estate, borrowers can rely on the benefit of lower monthly payments. But, at the end of the term, there will be a balloon payment, which consists of the remaining loan balance.
What Are Loan Amortization Schedules?
Once the loan’s amortization has been determined, a schedule is created to detail precisely how much each loan payment is being distributed. The two places the payment goes towards are the loan’s principal balance and interest.
Calculating Your Monthly Payment
When it comes to calculating your monthly payment, you’ll need to keep in mind the loan term vs amortization period to know precisely what you are paying.
There are four critical elements needed in calculating your monthly payment and developing an amortization schedule:
- Loan term
- Amortization
- Loan amount
- Interest rate
We’ll create a lending scenario by illustrating how these four components work together to form your monthly payment. You are an investor seeking a commercial real estate loan in this situation. Here are your loan terms:
- Loan term: 5 years
- Amortization: 20 years
- Loan amount: $1,000,000
- Interest rate: 6%
These variables can be plugged into a financial spreadsheet program or commercial property loan calculator to determine a payment amount of $7,164 per month rather than manually calculating the payment. But, when it comes to figuring out your amortization schedule, it becomes more challenging.
Calculating Your Amortization Schedule
Here is how you can calculate your amortization schedule in the first month of your loan:
- Payment: #1
- Beginning balance: $1,000,000
- Interest: $5,000
- Beginning balance $1,000,000 x interest rate 0.06 = $60,000 annual interest
- $60,000 annual interest / 12 months = $5,000
- Principal: $2,164
- Monthly payment $7,164 (calculated above) – interest $5,000 = $2,164
- Ending balance: $997,846
- Beginning balance $1,000,000 – principal = $2,164
Based on this example, your first loan payment of $7,164 will consist of $5,000 towards interest and only $2,164 towards the principal.
Here is how you can calculate your amortization schedule for the second payment of your loan:
- Payment: #2
- Beginning balance: $997,846
- Interest: $4,989
- Beginning balance $997,846 x interest rate 0.06 = $59,870 annual interest
- $59,870 annual interest / 12 months = $4,989
- Principal: $2,175
- Monthly payment $7,164 (calculated above) – interest $4,989 = $2,175
- Ending balance: $995,661
- Beginning balance $997,846 – principal $2,175 = $995,661
Based on this example, your second loan payment of $7,164 will consist of $4,989 towards interest and $2,175 towards the principal.
Calculating Your Balloon Payment
Once your amortization schedule continues for the entirety of the loan term and comes to an end, the remaining balance will be due as a balloon payment.
Based on the scenario above, here is how you can calculate the final payment of your loan and the remaining balance, or balloon payment due:
- Payment: #60
- Beginning balance: $851,901
- Interest: $4,260
- Beginning balance $851,901 x interest rate 0.06 = $51,114 annual interest
- $51,114 annual interest / 12 months = $4,260
- Principal: $2,905
- Monthly payment $7,164 (calculated above) – interest $4,260 = $2,905
- Ending balance: $848,996
- Beginning balance $851,901 – principal $2,905 = $848,996
Based on this example, your sixtieth and final loan payment of $7,164 will consist of $4,260 towards interest and $2,905 towards the principal. As a result, the remaining balance due is $848,996, which becomes your balloon payment.
Why It’s Important to Understand the Differences Between Loan Term vs Amortization Period
Your borrowing costs and mortgage flexibility can be directly impacted by knowing the differences between loan term vs amortization period. Your financial situation, both short-term and long-term, should be balanced by finding the right loan term and amortization period for your sale.
Over the life of your commercial real estate mortgage, you will likely experience multiple terms. That is unless you come into a ton of cash and pay down your mortgage early or have a very short amortization period. The good news is that the amortization remaining will be shorter at each term’s end because you have spent however many months or years prior paying down parts of the principal.
Additionally, it’s important to note that because commercial real estate loan terms are essential to the property’s cash flow projections, understanding the transaction details is crucial. To know the property owner’s level of cash available to be distributed, you must accurately be able to forecast the mortgage payment through the entire duration that they will hold the investment.
Conclusion
Understanding the loan term vs amortization period is just one of many elements of the ever-complex commercial real estate sale mortgage. For example, there are also nuances within small business loans, including the SBA 504 and the SBA 7(A).
Thankfully, commercial real estate lenders and brokers can seek out more qualified leads, negotiate fairer terms, and close on better deals easier than ever with the help of Finance Lobby.
Modernizing Commercial Real Estate Lending is a primary focus of the industry-leading commercial real estate financing online marketplace.
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