Businesses and individuals alike usually have to borrow money if they want to buy real estate. The type of financing you obtain will depend upon the type of building you buy. A commercial property is financed with a commercial loan, and a residential property is financed with a residential loan, but mixed-use properties can go either way.
Financing Real Estate With a Mortgage
Whether you're buying commercial property or residential property, if you want to finance the purchase, you'll need to sign a note promising to repay the money, but you'll also need to grant a mortgage to the lender.
A mortgage is a lien on real estate. A lien is a type of security interest that attaches to property in favor of someone other than the owner. If you borrow money and give the lender a lien, the lien stays on the property until you pay the loan back, either by installments or by selling the property. If you don't pay the loan, the lender can foreclose on the mortgage and sell the property to satisfy the debt.
When you obtain a loan for real estate, you will almost always need to give the lender a mortgage. The mortgage is recorded in the county where the property sits, putting the world on notice that the lender has an interest in the property. Mortgages can be placed on both commercial property and residential property.
What Is Residential Property?
As the term implies, residential property is property that is used for individual residence. Residential property includes single-family homes, duplexes and condominium and apartment units (the condo or apartment building itself may not be considered residential property, depending on the number of units in it).
Property is considered residential property if it falls under these categories, even if you rent it out to someone else, and even if it's owned by a corporate entity instead of a person. For example, a limited liability company may purchase a house and rent it out, and it's still considered residential to mortgage lenders.
What is Commercial Property?
Generally, commercial property is property that is zoned for and/or used for commercial purposes; that is, property where business is operated. Commercial property includes things like stores, shopping malls, warehouses, factories, office buildings and any other real estate that is used for generating income.
Apartment buildings may be considered commercial property, even though the space is used for residence. Typically, an apartment building with five or more units is considered "multi-family" and is commercial property for purposes of obtaining financing.
What Is Mixed-Use Property?
Mixed-use property is real estate that has both residential units and commercial units within the building. A good example of a mixed-use property is a row house or brownstone with a residence on the second and third floors and a business on the first floor, or on a smaller scale, a beauty salon that you run out of your house.
Mixed-Use Property Financing
If you're buying a mixed-use property or trying to refinance one you already own, you may have a bit more difficulty. Whether the loan is a commercial loan or a residential loan will usually depend on the percentage of the property used for each purpose.
If you can get a residential loan for a mixed-use property, it may be less of a headache than obtaining a commercial loan if you have limited resources. If you don't qualify for a residential loan, however, you can get a commercial mortgage for mixed-use property. In some cases, commercial loans are more flexible than residential loans.
Obtaining a Residential Loan
Residential real estate loans are obtained either through a broker or by contacting the bank directly on your own. You'll have to submit a loan application and provide details about your income and expenses. The lender will pull your credit report and also run a title search on the house to see if any other lenders already have liens. The lender will also require an appraisal to make sure the house is worth enough to cover the loss if you default on the loan.
Residential FHA Loans for Mixed-Use
The Federal Housing Authority (FHA) has a residential loan program that insures certain private residential mortgages. Not all home loans are FHA loans, but many are. If you want to buy a mixed-use property, you can do so if the purchase otherwise meets FHA guidelines. However, you must be able to show that the property is more residential than commercial. In numbers, that means at least 51 percent of the property must be used for residential purposes.
FHA loans also have loan limits that may cause trouble for a mixed-use property, which may be more expensive than an ordinary residential property. The limits vary, depending on where you live, so talk to your realtor or your broker about your options.
Residential Fannie Mae and Freddie Mac Loans
Fannie Mae and Freddie Mac are entities created by the federal government to provide support to the residential mortgage industries. They buy residential mortgages and either keep them or sell them on the secondary mortgage market. They are not lenders themselves, but they secure and privatize existing mortgages.
Mixed-Use Mortgages with Fannie Mae and Freddie Mac
These residential mortgage programs support mixed-use loans; however, they must meet certain strict criteria:
- The borrower must be the resident of the building and the owner of the business operating within the building.
- The property must be a one-dwelling unit.
- The property must be primarily residential.
- The property must be free of home modifications that would harm its marketability as a residence.
For instance, if you are a hair stylist and you do hair in your house, the property meets the criteria as long as you don't modify the home to make it less residential.
Commercial Real Estate Loans
If your property doesn't qualify for a residential loan based upon the percentage of commercial space versus residential, you can use a commercial loan. Most banks offer commercial loan products including commercial mortgage loans to finance the purchase of real estate. Qualifying for a commercial loan takes a little more work, and it may also take more out of you than a residential loan.
Like a residential mortgage, commercial mortgage applications require you to provide your financial information, and commercial lenders will appraise the property. They may require further security, though, including personal guaranties and liens on other assets.
Securing a Commercial Mortgage Loan
Lenders are more aggressive in securing their interests when making commercial loans. If the borrower is a business entity, the lender will likely require one or more of the business owners to personally guarantee the loan – that is, sign a document saying that if the business doesn't pay, the owner will be personally liable.
The lender may also require additional security if the corporation's finances aren't strong enough such as an additional residential mortgage on the owner's personal residence or a lien on personal property like equipment and inventory.
Commercial Loans Lack Consumer Protections
Commercial loans are also not subject to certain consumer protections that are available for residential loans. For example, collections on a commercial loan likely do not fall under the Fair Debt Collection Practices Act (FDCPA).
Some states have special laws that protect homeowners facing foreclosure, such as New Jersey, which has the Fair Foreclosure Act. Among other things, the Fair Foreclosure Act requires mortgage lenders to give homeowners 30 days' notice of intent to foreclose and provide a laundry list of information about their rights at the same time. Commercial mortgage lenders are not required to take any of these steps and can foreclose right away.
Different Terms for Commercial Loans and Residential Loans
Residential loans usually have repayment terms of 15 or 30 years with monthly payments based upon an amortization schedule. If the loan is a fixed rate loan, your interest rate will stay the same; if the loan is a variable rate loan, your interest rate fluctuates, and your monthly payments may change, but the term remains the same.
Commercial loans vary wildly in their terms. Some are amortized; others may require interest-only payments for a set number of years with a balloon payment due at the end (the maturity date). When such a loan matures, you may find that you still owe exactly what you borrowed, because your payments were only applied to interest.
Mortgage Prepayment Penalties
Residential mortgages do not have prepayment penalties. If you suddenly acquire $100,000 and want to pay off your house, you can do so. If you sell your house, you have to pay the mortgage off to pass clear title, and you won't be penalized.
Commercial mortgages, on the other hand, may have prepayment penalties. Because the bank made the loan with the expectation of receiving interest over a certain period of time on a certain principal balance, if you pay the loan off early, that interest income goes out the window. To make up for it, the bank charges fees when you pay the loan early.
- Hunt Real Estate Capital: Commercial vs. Residential Real Estate Loans
- Nolo: Pros and Cons of Investing in Commercial Real Estate
- Investopedia: Commercial Real Estate Loan
- Realty Times: How to Finance a Mixed-Use Property
- Investopedia: What is Commercial Property?
- FHA News and Views: FHA Loans, Eligible Property Types and Mixed-Use Properties
- Federal Housing Finance Agency: Fannie Mae & Freddie Mac
- Fannie Mae: B2-3-04: Special Property Eligibility Considerations (02/23/2016)
- Nolo: New Jersey Foreclosure Procedures
Rebecca K. McDowell is an attorney focusing on creditor and debtor law. She has a B.A. in English and a J.D.