Table of Contents
The 504 loan is a government program that provides loans to small businesses and entrepreneurs. The SBA calculates your credit score which determines what amount you will be able to borrow. This article breaks down the basics of how these loans work, as well as some examples on how they can help an entrepreneur get their company off the ground.
The Small Business Administration’s SBA 504 loan program combines two loans—one from a lender and the other from a community development corporation (CDC)—for commercial real estate and other fixed assets like equipment. The lender part of the loan covers up to 50% of the loan, the CDC portion covers 40%, and the borrower is liable for the remaining 50%.
What is an SBA 504 Loan?
SBA 504 loans are commercial real estate loans that include two loans: one from a conventional bank and one from a community development corporation (CDC). The SBA 504 loan’s lender and CDC portions are both closed at the same time. SBA 504 loans are available for up to $14 million, with periods up to 25 years and cheaper interest rates than conventional bank loans.
SBA 504 Loans: What Can They Be Used For?
An SBA 504 loan may be used to buy land and existing structures, make upgrades and repairs, or construct a new facility. SBA 504 loans may also be used to fund other fixed assets like equipment and machinery, as well as to repay a debt that was used to purchase fixed assets.
The SBA’s Regional Communications Director, Andrea Roebker, says:
“A 504 loan is intended to help with fixed assets, such as real estate purchases, construction/renovation of real estate, and long-term machinery and equipment purchases.”
CDC/SBA 504 loans may be utilized for the following reasons, according to SBA loan regulations:
- Purchasing land and existing structures on the property
- Investing in property upgrades such as parking spaces, utility connections, and landscaping
- Constructing a new facility
- Purchasing additional long-term fixed assets such as equipment and machinery
- Debt refinancing: An SBA 504 refinance applies to debt acquired mainly for the purpose of acquiring 504-eligible fixed assets; the current debt must be at least two years old and in good standing.
What Can’t SBA 504 Loans Be Used For?
SBA 504 loans are excellent for commercial real estate, but there are a few things you can’t do with the money.
The following are some of the limited uses for SBA 504 loans:
- Working capital
- Materials, supplies, or inventory
- Advertising and marketing?
- Typical operational costs
- Investing in speculative real estate
SBA 504 Loan Requirements
An SBA 504 loan is quite comparable to a conventional commercial real estate loan in terms of qualification. You must be able to show your capacity to repay the loan and have a clean credit history.
The following are some of the fundamental qualifications:
- 680 is the minimum credit score.
- Debt service coverage ratio (DSCR): at least 1.25x; your DSCR is calculated by dividing your yearly net income by the total of your annual principal and interest payments on your loans, which include the SBA 504 loan and any other current debt commitments.
- 10% to 20% of the total CDC/SBA loan amount is required as a down payment.
- In your personal or company financial history, there should be no recent bankruptcies, foreclosures, tax liens, or overdue government loans.
The SBA 504 loan program has four specific requirements in addition to the general SBA loan requirements: the property must be owner-occupied, the loan must create or retain jobs, the business must have a net worth of less than $15 million, and any equipment purchased with the loan must have a service life expectancy of at least 10 years.
1. The property must be inhabited by the owner
The property must be at least 51 percent owner-occupied to satisfy the SBA 504 criteria. You may rent out a portion of the building, but the bulk of it must be used for your company. If the loan is for new construction, the building must be at least 60% owner-occupied when it first opens, eventually rising to 80% owner-occupancy over the next ten years.
2. To create jobs
You’ll have to explain how you’ll utilize the loan funds to generate or maintain employment that might otherwise be lost, as well as how you’ll support public policy objectives, as part of the loan application process. The current requirement is that for every $65,000 of financing, one job must be generated or maintained. For small manufacturers, this rises to one job every $100,000 financed.
Other public policy objectives, such as energy conservation and minority company growth, may also help you qualify for an SBA 504 loan.
3. You have a net worth of less than $15 million dollars.
For the previous two years, your company must have a tangible net value of less than $15 million and an average net income of less than $5 million after taxes.
4. A minimum of ten years of equipment life
Any equipment purchased with the funds must have a minimum economic life of ten years. Machinery and bigger industrial or commercial-use equipment are examples of approved goods.
Maximum SBA 504 Loan Amount
The highest amount you may borrow with an SBA 504 loan is $14 million under current SBA regulations. The amount your project qualifies for may be reduced owing to limitations on the use of profits and qualified projects. Because of the time and effort needed to complete a 504 loan, most banks prefer to offer SBA 504 loans for projects worth $500,000 or more.
Rates and Fees for SBA 504 Loans
You may anticipate cheap interest rates and minimal costs with an SBA 504 loan. The annual percentage rate (APR) on the bank component of the loan will typically vary between 4% and 10%. The CDC component of the loan has a fixed rate that presently ranges from 2.5 percent to 3% APR.
Keep in mind that an SBA 504 loan consists of two loans. The first is a loan of up to 50% of the entire loan package from a conventional lender, such as a bank. There are minimal limitations on the rates, conditions, and fees for that part of the agreement. As a result, they may differ from one borrower to the next. When compared to alternative financing choices, most individuals find commercial real estate loan rates and conditions for this part of the transaction to be extremely advantageous.
The CDC is responsible for the second portion of the loan, up to 40% of the total package. This part of a 504 loan is tightly controlled in terms of rates, terms, and fees. The CDC loan is a fully amortizing, fixed-rate loan with a term of 10, 20, or 25 years. It functions similarly to a conventional mortgage loan. The borrower makes equal monthly payments for the duration of the loan, after which the debt is paid off entirely.
Interest Rates and Fees for SBA 504 Loans: CDC Portion of the Loan
The interest rate on the CDC component of the 504 loans is based in part on Treasury notes sold at auction on a monthly basis for the 20- and 25-year loans, and biweekly for the 10-year loan. Three fees make up the balance of the CDC loan interest rate:
- SBA guarantee cost: This is a monthly SBA guarantee charge of.914% of the principal amount of the note, computed at five-year intervals, starting with the first payment.
- Fee for the central servicing agent (Wells Fargo): The Central Servicing Agent (Wells Fargo) receives an extra 0.10 percent of the principal amount of the note at five-year intervals.
- The CDC’s service charge ranges from 0.625 percent to 2.00 percent, with a maximum of 1.50 percent in rural regions. The CDC will pay the SBA 0.125 percent per month and retain the rest.
The interest rates on the CDC component of the 504 loans are as of June 2021:
- 2.612 percent for a ten-year period
- 2.764 percent for a 20-year period
- 2.883 percent for a 25-year period
One-time Fees for the CDC Portion of the SBA 504 Loan
There are certain one-time costs associated with the SBA 504 loan. These will be funded into the loan and amortized throughout its duration.
The following are examples of one-time costs:
- 0.375 percent to 0.4 percent underwriting fee
- Fee for processing: up to 1.5 percent
- Legal fees range from $2,000 to $5,000.
- 0.25 percent funding fee
- 0.5 percent guarantee fee
While all of these costs may appear daunting when seen separately, when all of them are added together, they only amount to 2.5 percent to 3% of the loan’s value and will be amortized over the life of the loan.
Prepayment Penalty for the CDC Portion of the SBA 504 Loan
Prepayment penalties are prevalent in commercial real estate loans, and an SBA 504 loan has them as well. The penalty for early payment is determined on a sliding scale. Only the CDC part of the loan is penalized, and the penalty is calculated using the debenture interest rate at the time the loan was granted, not the effective interest rate of the loan.
The penalty for a loan with a 20- or 25-year maturity applies for the first 10 years of the loan and then reduces by 10% each year. The penalty for a loan with a 10-year maturity applies for the first five years of the loan and then reduces by 20% each year.
Assume that a 20-year loan was granted with an effective interest rate of 4.060 percent for the month of July 2019 and a debenture interest rate of 1.980 percent. Each year, the prepayment penalty is reduced by 10% of the debenture rate. Every year, it decreases by a factor of.198 percent.
The prepayment penalty percentages for this scenario would be as follows:
CDC Prepayment Penalty on SBA 504 Loans
Remember that, despite the modest prepayment penalty, SBA 504 loans are assumable. Don’t underestimate the value of having a new borrower take on a 504 loan with 16 or 17 years left at a low fixed rate of 4.060 percent. What could be more attractive to a future buyer than the chance to take up a fixed-rate loan in these price ranges?
Interest Rates and Fees for SBA 504 Loans: Lender’s Portion of the Loan
The interest rate provided on the lender part of an SBA 504 loan is up to the bank or non-bank lender’s discretion and usually varies from 4% to 10%. Finally, you and your agents must work out the best rates, fees, and conditions for your transaction.
Interest Rates and Fees for SBA 504 Loans by Lender
In most instances, a bank or nonbank lender loan will have a five- to ten-year term with a 20- to 25-year amortization period. When it comes to 10-year loans, the interest rates typically reset after five years. This implies that your interest rate may go down, increase, or remain the same after five years. It is dependent on the market rates at the moment.
While the lengthy amortization lowers your monthly payment, it also implies that unless you refinance the remaining amount, you will have a balloon payment due in five to ten years. In certain instances, refinancing the first mortgage when a balloon payment is due may be difficult. It may be difficult to locate a lender ready to cooperate with you if your company has a slump prior to refinancing, or if your property has substantially depreciated.
Closing expenses and third-party charges, including appraisal fees, environmental fees, architectural fees, and legal fees, may be included in the bank share of the loan. Fortunately, they may often be included in the financing.
The Top 4 Advantages of an SBA 504 Loan
In Federal Fiscal Year 2020, the SBA insured approximately 17% more 504 loans than in Federal Fiscal Year 2019, continuing a trend that began many years ago. The popularity of the SBA 504 program among companies is due to the many benefits it provides borrowers. Low-interest rates, a little down payment, lengthy payback periods, and no extra collateral are the four main advantages of an SBA 504 loan.
1. Interest Rates That Are Low
The SBA caps interest rates on the CDC component of the loan, which presently vary between 2.6 percent and 3 percent. That rate is set in stone and will not change for the duration of the loan. These restrictions do not apply to the bank loan. The rates are usually between 5% and 10%, and they may be either fixed or variable.
2. Low Initial Payment
Unlike most conventional commercial loans, which need a 20% to 40% down payment, an SBA 504 loan only requires a 10% down payment. A 15% down payment is required if your company is a startup or the property you intend to purchase is a single-use structure. For companies buying single-use buildings, the down payment threshold rises to 20%.
Even if you’re a fledgling company looking to buy a single-use facility, the SBA 504 loan’s 20 percent down payment requirement is beneficial. Many conventional lenders may be reluctant to lend to a startup, and if they do, it will almost certainly need a significantly higher down payment.
3. Repayment Terms That Are Long
The CDC component of an SBA 504 loan has a 10-year term for equipment and 10-, 20-, or 25-year maturities for real estate, while most conventional commercial mortgages are five to ten years. The bank component of the loan is typically seven years for equipment and ten years for real estate. The CDC loan has a longer payback period, which lowers the monthly cost and makes it more affordable.
4. There will be no further collateral
The collateral for an SBA 504 loan is usually real estate or other fixed assets that are being funded. Your remaining assets are lien-free since no further collateral is needed beyond the real estate or fixed assets you’re financing.
How to Obtain an SBA 504 Loan
Any bank, credit union, or commercial lender that works with the SBA may finance the bank component of an SBA 504 loan. Many financial institutions will work with CDCs and may help in the search for a CDC partner. A local CDC, on the other hand, may collaborate with a number of banks in the region.
There are 243 CDCs in the United States. We recommend utilizing the SBA’s CDC Finder tool to locate one that will work with you. SBA district offices may also be able to provide rankings of the best 504 lenders in your region.
A business strategy and financial forecasts will be needed when you apply. In addition, the application will need the submission of the business’s last three tax filings, as well as any owners with a 20% or higher ownership stake.
Conclusion
An SBA 504 loan is one of the first kinds of financing you should look into. Because of the low down payment, your small company will be able to save more money for working capital, and the low-interest rates and lengthy payback periods will make your cash flow simpler.
