Caveat Emptor ‘Let the borrower beware’

By David Main, President of HCDC

Small business owners face a barrage of financial decisions when it comes time to grow and expand. As part of that decision-making process, borrowers should take a close look at the loan programs offered by the U.S. Small Business Administration (SBA), specifically the SBA 504  Loan Program and the SBA 7(a) Loan Program. These two popular loan programs have distinct advantages for lenders and borrowers – depending on the project.

Quick Background on SBA

Except for disaster loans, the SBA does not make direct loans to businesses. Instead, the SBA guaranties small business loans through intermediaries such as banks and Certified Development Companies (CDC’s) to deliver these loan programs.  In order to obtain an SBA guaranteed loan, a small business needs to approach a lending partner such as a bank for a SBA 7(a) loan or a CDC for a SBA 504 loan. Banks may already be offering both the 7(a) and the 504 loans, but the small business needs to know the difference, especially when it comes to the fees and structure of the loan to make an informed decision.

How to choose between a 7(a) or 504 loan?

If a borrower is seeking working capital or financing leasehold improvements, then the options for SBA financing are limited to the 7(a) loan program.  However, if the financing involves buying a building, ground-up construction, building renovation, or the purchase of heavy machinery and equipment, the borrow needs to look at the SBA 504 loan program.

The SBA 504 loan program was actually designed for small businesses to finance commercial real estate for use in business operations.  Meanwhile the SBA 7(a) loan program was originally designed for higher risk loans; like the acquisition of a business, working capital, or furniture and fixtures, and leasehold improvements.  Such loans were considered to be high risk because of very weak, limited, or even no collateral.

Financing owner-occupied commercial real estate is considerably less risky, yet many banks still only offer SBA 7(a) loans as the option for real estate.  The reason is simple: there is more fee income for the banks. Depending upon how the bank lending officers are commissioned, there is more earnings potential with the 7(a) loan than the 504 loan program, even though overall the latter may be more beneficial for the small business borrower.

Benefits of the 504 Loan

The 504 Loan program offers borrowers a fixed rate for 10 or 20 years, with lower fees than the 7(a) program, and often a lower down payment of 10%.  Additionally, fees on the 7(a) loans tend to rise with the project size. For example, the guarantee fee for a loan over $700,000 is 3.5% for a project up to $1 million. When the project exceeds $1 million the rate jumps to 3.75%.  However with the 504 loan, the fees involved stay flat as a percentage when the loan amount increases. On a $1,250,000 commercial real estate project the fees for a 7(a) loan can top $36,000, while the fees for a 504 loan are just over $22,000.

In regards to interest rates, the 7(a) loan typically has a variable rate.  While such rates are historically low now, they are currently rising and will continue to do so making it a more expensive proposition.  Some banks do offer fixed 7(a) interest rates for 20 to 25 years.  However, they also make money by selling off the guarantied portion of the 7(a) loan on the secondary market at a premium depending upon how the deal is structured for as much as 10 to 16% of the guaranty.  The premiums that the lenders receive when they sell the loan are higher for variable rates, and for longer term loans with prepayment penalties.

In addition, the 7(a) loan program has the “All Collateral Available Test.” This is where a small business borrower typically has to pledge all collateral available, including their personal residence to secure the loan.  This test does not exists with a 504 loan.

After weighing all the facts, financing real estate with a 504 loan or a 7(a) loan isn’t even a contest.  The 504 loan is clearly safer and better for the borrower’s bottom line and can be an important tool for small business growth.