When the time comes for a business to expand or remodel, the U.S. Small Business Administration’s 504 loan is one option for financing for fixed assets such as real estate and equipment.
With an SBA 504 loan, a bank funds a portion and a Community Development Corporation (CDC) funds a portion, along with the down payment from the borrower. Maximum loan amounts range from $5 million to $5.5 million, depending on the type of business or project.
But one of the components of the 504 loan — the prepayment penalty — is frequently misunderstood by lenders and incorrectly believed to be a flat 10 percent of loan balance. Simply put, this is a “swing and a miss,” even though it is a commonly held belief of many finance professionals, which often prevents them from offering the 504 program to their customers.
The SBA 504 20-year fixed rate debenture carries a 10-year prepayment penalty, and the 10-year fixed rate debenture has a five-year prepayment penalty, as required by the SBA. But it is the debenture rate that sets the percentage or the amount of the prepayment penalty — not a flat 10 percent of loan balance. It is based on the actual debenture rate, which typically has been about 160 basis points less than the note rate to the borrower.
Consider the following example: You close on a 20-year SBA second mortgage debenture for your customer in the amount of $1 million in January 2018 at the current debenture interest rate of 2.92 percent (4.62 percent interest rate to borrower).
Fast-forward to January 2021. The customer comes to you stating that she has outgrown her space and wants to sell the property and move to a larger building.
In our example, the principal balance of our $1 million debenture is now (three years later) approximately $903,000.
The prepayment penalty due would be calculated as follows:
1. The debenture interest rate determines the amount of the prepayment penalty.
2. The prepayment penalty begins in year one. It is calculated by multiplying the debenture rate of interest by the principal balance on the debenture.
3. The prepayment penalty then declines by 1/10th of the debenture rate annually on a 20-year debenture for the first 10 years. After that, the penalty is 0 percent:
- Through Jan 2019: 2.92% of $970,000, or $28,324 prepayment penalty
- Through Jan 2020: 2.63% of $937,000, or $24,643 prepayment penalty
- Through Jan 2021: 2.34% of $903,000, or $21,094 prepayment penalty
4. The prepayment to pay off the loan in year three by the end of January is $21,094.
Please contact your local SBA office to find a CDC in your area and learn how a long-term fixed rate loan can benefit your bank customers.