Commercial Lending and Deposits 101

Loans are a critical part of business operations, and so is understanding how they work. No matter how big or small a business is, it will likely take out a loan at some point in its lifetime. Many may think of business loans as something that only happens during the initial stages, but loans can also help with expansions, covering unexpected expenses, or even keeping things operational during tough times. 

 For businesses seeking loans, some common questions will arise:

• What kind of loan should I get?
• Where should I go to apply for a loan?
• Is a loan even the right call for my business?

Commercial and industrial lending can fill any one of these needs. Commercial and industrial loans (or C&I loans) come in many forms depending on the need, and are commonly only thought of as being offered by specific types of banks—namely, commercial banks. However, as you’ll soon learn, commercial banks aren’t the only places that offer lending to businesses, so it’s worth understanding your options.

Commercial loans serve a variety of functions, all of which help support businesses. If an organization takes advantage of these services, they stand to have a much easier time with operations, payroll, and many other critical business functions. With this guide, you’ll learn more about the basics of commercial banks, some types of commercial loans, and how companies get the financial support they need through commercial lending—as well as how credit unions like  Indiana Members Credit Union may be able to help even more than a typical commercial bank.

For your convenience, this article divides into the following three sections:

• Part 1: What Is a Commercial Bank?
• Part 2: Services of a Commercial Bank
• Part 3: Commercial and Industrial Lending

 To start, let's talk about the basics of commercial banking: how it works, why it exists separate from other types of banking, and how deposits are secured in a commercial bank or credit union.

(NOTE: The phrase “financial institution” is used throughout this article as a stand-in term for any organization that provides banking services. This includes not just commercial banks but credit unions and similar institutions.)

Part 1: What Is a Commercial Bank?

A commercial bank is a type of financial institution that offers banking services to private individuals or small businesses—specifically for a profit. Many businesses  fulfill all their banking needs at a commercial bank; some examples include checking accounts, savings accounts, and personal loans for large purchases. Businesses may also take out loans for a variety of reasons. A medical practice, for example, may take out a loan to purchase new equipment or ambulatory vehicles.

In addition to account services and loans, commercial banks may also offer basic financial products such as certificates of deposit (CDs). While many people and businesses use commercial banks for their account services, others also use regionally-based institutions such as  community banks or  credit unions, who usually offer more benefits to their members.

 

Do Commercial Banks Take Deposits and Lend Money?

Yes—and they need to do both in order to function properly. Let’s discuss why both deposits and lending are critical to banks and credit unions.

Deposits matter to any financial institution because they need to have money in order to be able to lend it. They create this cache of cash by accepting deposits, meaning that they need clients to open accounts with them and store money with their institution. Essentially, they are making a deal with each client they serve: “We’ll keep your money safe and accessible, and in exchange you allow us to use it until you need it back.” They then use this money to give out loans, which they profit on via collecting interest.

A financial institution literally banks on people wanting to keep their money in its accounts. If everyone who kept money in that institution were to ask for it back at the same time (like, say, during an economic crisis), the institutions would most likely not have that money to give, and would possibly go under as a result. To protect against this, banks and credit unions are required to hold onto a certain  percentage of their funds as a backup for such emergencies.

As hinted to in the previous paragraph, lending is vital to the success of banks and credit unions. Commercial banks, for example, are for-profit institutions that primarily make money by collecting interest from what they loan out to individuals and organizations. Clients may pay interest on various types of loans—be they for a business, car, mortgage, or any other lending service. Companies may also take out loans with a bank or credit union for a variety of reasons, such as expansion, equipment leasing, or simply to survive an economic downturn. Of course, these institutions don’t just collect interest; many may also pay interest to clients that keep their money in accounts. This is them essentially paying their clients for banking with them—and by extension, enabling the institution to provide loans and credit.

While interest dividends are a nice benefit of using a commercial bank, some may not want to bank with a for-profit financial institution. Commercial banks often charge higher interest rates on loans or have harsher terms as a whole, making them less accessible in general to the average individual or small businesses. In these cases, a person or business may be better off banking with a non-profit institution, such as a  credit union. Credit unions typically have better rates, more deals, and offer more personalized services to their members. Also, since credit unions are not-for-profit organizations, any “profits” a credit union would make funnel back to members as reduced fees, higher savings rates, lower interest rates, and other perks. This is because people who bank at credit unions are not just members—they are, quite literally, partial owners.

What Is the Difference Between Deposit and Lending?

Deposits and lending are more or less inverses of each other. Deposits are amounts of money given to a bank/credit union with the intent of retrieving it at a later date. Lending, on the other hand, is money that comes from the institution—money that is given to a client with the intent that they will pay it back per the terms.

What Is the Role of a Commercial Bank?

The role of commercial banks in economic development is hard to understate. In short, commercial banks and credit unions make the national economy more stable and create opportunities for growth. Financial institutions use the money stored in their accounts as the backing for their loans and investment services. These services are the backbone of  credit, which enables a higher level of economic production, employment, and spending overall. These services not only create capital, but help with the market’s liquidity as well.

What Does “Liquidity” Mean?

Basically, liquidity refers to the ease with which assets can be converted into cash without diminishing their value. In the case of a bank account specifically, there is almost zero lost value when taking money out, which makes them like a highly-liquid asset. In addition to providing liquidity, owning a bank account provides financial security and makes it easier to access certain services, such as financial advising or lending. Most financial institutions will require their clients to open an account with the financial institution before lending out money. For example,  IMCU requires individuals to at least have a savings account when taking out an auto loan or mortgage.

How Are Bank Deposits Secured?

Deposits are protected by one of two ways, depending on whether you use a bank or a credit union. The  Federal Deposit Insurance Corporation (FDIC) and  National Credit Union Association (NCUA) are independent government entities that protect deposits made in banks and credit unions, respectively. They also insure credit unions and protect them from collapse. Financial institutions will showcase their affiliations with either of these organizations to make their members feel safe and secure; for example, the  Indiana Members Credit Union (IMCU) displays their NCUA affiliation on their website.

 

Part 2: Services of a Commercial Bank

This section will dive deeper into the services offered by commercial banks or credit unions, some of which were discussed briefly in Part 1. We’ll discuss the basic services they provide, with a special focus on commercial lending for small-to-midsize businesses.

 

What Are the 3 Main Types of Banking Services?

Banks typically provide the following three basic services:

1. Checking Accounts | These are deposits that clients generally use to pay bills, withdraw cash, and store their money for safekeeping. These accounts usually pay little or no interest. They may even come with usage fees, monthly fees, or both.
   
   
2. Savings Accounts | This type of account offers a way for clients to safely deposit and store money in a federally insured location. Savings accounts will also typically offer a higher payout in interest. An adjacent but similar type of service is certificates of deposit (CDs), which will usually offer even higher rates of return.
   
   
3. Lending Services | Banks and credit unions make loans to clients and businesses. They turn a profit by charging more interest on their loans than they pay out to their savings account holders. For example, if a financial institution pays savings account holders a 1% annual interest rate, they may charge a minimum of 6% on their loans, creating a profit margin of 5%. Since banks are owned by shareholders who specifically want to earn a profit, they will likely charge higher interest rates than not-for-profit financial institutions such as credit unions.

The first two services, checking and savings accounts, are relatively simple concepts that are commonplace in today’s world. Lending services, however, get much more complicated—especially when you consider commercial and industrial loans (or C&I loans, for short). Various types of C&I loans exist to fulfill the needs of their businesses’ commercial deposit accounts, and each business’s financial needs may vary greatly depending on the nature of their operations.

What Are Commercial Deposit Accounts?

Commercial deposit accounts are basically bank accounts for businesses. An organization may use a commercial account to not only store their money, but access services such as lending, treasury management, real estate needs, credit lines, and even equipment leasing. Companies in just about every industry can benefit from a commercial account, as the many services they provide can greatly assist with business operations. The phrase “commercial account” may also simply refer to the relationship between a business and a financial institution, which might encompass any number of the aforementioned services.

Next, let’s discuss commercial and industrial lending—and how each differs from consumer lending.

 

Part 3: Commercial and Industrial Lending

Commercial and industrial loans (or C&I loans) are loans for a business or organization through a financial institution. This debt-based funding can take many forms, depending on the industry of the business and the nature of their need for the loan. But in most cases, C&I loans serve a short-term need for business operations. Many businesses use commercial lending, including medical practices, manufacturers, construction companies, and more. These businesses can take out C&I loans through a bank or credit union.

What Is the Difference Between Commercial and Industrial Loans?

For clarity, let’s first stress that “commercial and industrial loans” refer to one type of loan. This is not meant as “commercial loans” and “industrial loans,” but one unified type of loan known as “commercial and industrial loans” (alternately, "commercial" or "C&I" loans). Commercial loans exist in opposition to consumer loans, which are typically for an individual person. These two loan types differ mainly in purpose; commercial loans are investments in a business, whereas consumer loans help individuals make larger personal purchases. Common things people finance in this way include cars and homes. 

 There are many reasons a business might take out a commercial and industrial loan—growth, equipment leasing, and emergency funding, to name a few. And depending on the financial institution that’s supplying the loan, there are different possible terms.

 

What Are the Typical Terms of a Commercial Loan?

The answer to this is somewhat complicated because C&I loans take many forms, depending on the nature and size of the loan. To make matters more complicated (as if they needed to be), the “term” of a C&I loan can either mean the timeframe in which the loan is paid off, or one of many general types of possible C&I loan. Different types of C&I loans include asset-based loans, equipment finance loans, secured term loans, and many others.

Truthfully, there are no “typical” commercial loans—but there are some typical parameters to look out for. First, let’s start by defining some key parameters to watch for in C&I loans.

• Size | Simply put, this refers to how much money the business loan is for.
  

• Purpose | For a business, this might be expansion, equipment leasing, or emergency funding.
  

• Credit Score Requirements | As the name suggests, this is the minimum score for approval.
  

• Term | As discussed previously, “term” can mean multiple things when discussing a loan. When talking about loan parameters, a loan’s “term” is the timeframe in which a loan will be paid in full if all payments are made on-schedule. Terms can be anywhere from 3-5 years long all the way up to 20 years. Generally, a longer term will mean lower monthly payments, but ultimately a higher total amount of interest paid over the course of the loan.
  

• Amortization | Essentially, this refers to how much of your payments are going to interest versus the principal (or the initial balance borrowed). The amortization of a loan, then, is the ratio between principal and interest that your payments go to throughout the loan. Typically, if you pay the agreed-upon amount for each payment, the initial payments will go mostly to interest, with the scales slowly tipping over time towards paying the principal until the loan is paid off.
  

• Debt-Service Coverage Ratio (DSCR) | DSCR refers to the relationship between a business’s incoming cash flow and its ability to pay off debt obligations. Of course, the better this ratio is, the more attractive that business will be as a borrower.
  

• Loan-To-Value Ratio | Also known as the LTV ratio, you will typically see this in commercial real estate loans. LTV ratio is the relationship between a loan’s amount and the appraised value of the property for which the loan is taken. A 75% LTV ratio, for example, would mean that the loan is worth 75% of the property’s appraised value. Financial institutions  use LTV ratio to determine the risk of a loan and whether it is sensible to approve that loan. Generally, a lower LTV ratio means more favorable terms for the borrower, while a higher LTV may require the borrower to get mortgage insurance. For example, if a business wants to buy a property worth $10 million, taking out a $6 million loan (60% LTV) will see far more competitive rates than an $8 million loan (80% LTV).

 
How Is Commercial Lending Regulated in the US?

Typically, commercial lending is far less regulated than consumer lending. While consumer lending has a lot of protections that are mutually beneficial for lenders and borrowers alike, commercial lending has historically not had much regulation. However, that is changing—and fast. The  landscape of lending is evolving, and more commercial lending regulations are being introduced to provide more transparency to borrowers. 

New regulations like the  Truth in Lending Act (TILA) help protect consumers and businesses from predatory lending practices with several safeguards. For example, loans covered by TILA have a three-day rescission period, which gives borrowers time to reconsider or even back out of a loan agreement. Another example is Section 1071 of the Dodd-Frank Act amending the Equal Credit Opportunity Act (ECOA). This section requires financial institutions to “compile, maintain, and submit to the Bureau certain data on applications for credit for women-owned, minority-owned, and small businesses…for the purpose of:

• Facilitating enforcement of fair lending laws
• Enabling communities, governmental entities, and creditors to identify business and community development needs and opportunities for women-owned, minority-owned, and small businesses.”

While these types of protections are great to have, it’s always best to do your research before taking out a loan with a financial institution. Make sure they are trustworthy and have your best interests at heart, and aren’t just trying to make a profit off of you.

Now that we’ve talked about C&I loans as a whole, let’s talk about what you need to know in order to get one. Let’s start with an idea we referenced earlier: the “5 Cs of Commercial Lending.”

 

What Are the 5 Cs of Commercial Lending?

The 5 Cs of Commercial Lending (or the 5 Cs of Creditworthiness) is a critical concept for business owners to understand before applying for a loan. Financial institutions will evaluate these 5 Cs when considering if an applicant should receive a loan—and if so, how big of a loan they can be trusted with.

The 5 Cs are capacity, capital, collateral, conditions, and character. Let’s examine each in further detail.

1. Capacity | This “C” encompasses your ability to repay a lender. Financial institutions will want to examine your debt-to-income ratio as a business, and make sure that there is sufficient cash flow (the next “C” we’ll discuss) to justify a loan. Essentially, lenders use this criteria to determine if you will have the capacity to pay off a new debt.
   
2. Capital | Also known as cash flow, this refers to the financial institution’s assessment of how much money is coming in and out of your business. Since seizing collateral is a difficult, time-consuming process (which we’ll talk about next), banks/credit unions want to see that you can comfortably make the payments back on your loan—“comfortably” meaning that you have a reasonable cushion between your revenue and payments. For example, if your proposed loan payments are $1,000 each month, the institution would likely want to see a difference of at least $1,250 between your monthly revenue and expenses, which would provide a 25% cushion for the payment.
3. Collateral | In the event that your business cannot pay back the loan, financial institutions want to be able to reclaim the loan’s value—even if that’s in the form of physical assets. This forms the concept of collateral: anything pledged as security for the repayment of a loan. When a loan is for a physical item, such as a car or house, the collateral is the item itself. But for commercial loans, where the need is typically more abstract, the bank/credit union will want the business to pledge something of value—or multiple things—as collateral. With this, it’s worth noting that financial institutions typically do not want to go through the process of seizing collateral. Thus, they will scrutinize their applications heavily before giving out a loan, even if they know they’ll have sufficient collateral.
   
4. Conditions | This criteria is more of a birdseye view—lenders are zooming out to look at the conditions of the loan and the economy or industry of the business. While some of these conditions are out of your control as a borrower (like global economic conditions), you can demonstrate that you have a strong financial position and an excellent reason for incurring debt. 

5. Character | While this last part is largely subjective, a financial institution’s judgment of character can be a deciding factor when considering a loan application. There are still certain things every business owner can do when applying for a loan to make themselves look like an appealing applicant. For example, as a business owner, both your business and personal credit scores are typically considered when applying for a commercial loan. With any loan, financial institutions are looking for a history of responsible money management—and a credit score is one of the quickest ways to appraise financial dependability. This is especially important for business owners to keep in mind, because while credit may not tell the whole story of your financial situation, banks/credit unions will have a hard time looking past a low credit score or damaging penalties. Make sure you practice good financial management—not just in your business, but your personal finances as well. In some cases, the institution itself may even be able to help you with financial literacy. Institutions like  IMCU place a heavy emphasis on educating their members, and offer a variety of ways to help.

Which Type of Bank Is Best for My Business?

As a business owner, you want to find a financial institution that’s going to help you get the best deal possible, especially if you’re a small to midsize business. In these cases, a commercial bank may not be the best option because they have higher rates and less personalized services. 

 Compare this to a regional institution such as  Indiana Members Credit Union. In addition to providing common banking services, we are best known for our competitive loan rates and high-touch customer service. We work with each of our clients on a close basis—both at the individual and business level—to make sure they are thriving and successful. And because we are a non-profit organization, every bit of our success goes back to our members—and that could include you.

 Want to learn more about commercial loans and what your options are? IMCU is here for you. Please visit our website and  submit an inquiry, or come to a branch in-person. We would be happy to help you.