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SBA 504 Loan: What Is It and How Does It Work?
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Scaling a small business can be a challenge when you don’t have enough money to fund your big ideas. Maybe you want to invest in a larger facility or buy machinery that would improve your product. If you need to finance a purchase for your business, the Small Business Administration (SBA) has an option you might consider.
An SBA 504 loan makes it possible for small businesses to secure funding to purchase fixed assets, like land, machinery and buildings. The SBA guarantees a portion of the loan, so borrowers who would otherwise struggle to get financing have an option.
- What is an SBA 504 loan?
- How do SBA 504 loans work?
- Who is eligible for an SBA 504 loan?
- How to get an SBA 504 loan
- SBA 504 vs. 7(a): What’s the difference?
What is an SBA 504 loan?
An SBA 504 loan offers long-term, fixed-rate financing for small businesses to purchase fixed assets. There are three parts, including a low down payment made by the borrower; a loan from a certified development company (CDC) that is guaranteed by the SBA; and a loan from a bank or other lender.
We’ll break down the three parts:
- 10% down payment: The borrower is required to make a down payment of at least 10% (and in some cases more) on the loan.
- 40% certified development loan: A CDC offers financing of up to 40% of the loan amount. This amount is guaranteed by the SBA.
- 50% bank loan: A bank or a credit union offers the remaining financing, which needs to be at least 50% of the total loan amount.
According to William Manger, associate administrator for the Office of Capital Access at the U.S. Small Business Administration, the SBA has seen a 35% increase in SBA 504 loans over the last year. This is in part thanks to some changes the SBA has made, like extending the maximum term length of the loan and decreasing the job-per-dollar ratio requirement, which is how many jobs a borrower must create for every set increment they borrow through a 504 loan.
How do SBA 504 loans work?
Because the SBA guarantees a portion of the loan, the loan has specific terms and requirements that you won’t find with a typical commercial loan.
The maximum loan amount for the CDC portion of the loan that is guaranteed by the SBA is $5 million. However, this amount increases to $5.5 million for small manufacturers and some green energy projects and companies. Manger noted that even though the maximum loan amount is $5 million (or $5.5 million in some cases), the average CDC portion is under $1 million.
The third-party lender — a bank, credit union or other lender — is required to provide at least 50% of the funding. The SBA doesn’t restrict the project size, so a third-party lender can lend you more than the required 50%, meaning your loan can be $20 million or more.
As a borrower, you’re required to make a down payment of at least 10% of the total loan. In some cases, you may be required to make a down payment of up to 20%.
If you’ve been in business for less than two years, or if the loan is to be used for a limited-market or special-purpose property (e.g., amusement parks, bowling alleys or gas stations), you’ll put down at least 15%. If you’ve been in business for less than two years and the loan will be used for a limited-market or special-purpose property, you’ll put down 20%.
The term length of the CDC loan ranges from 10 to 25 years, depending on your intended use for the loan. Machinery or equipment typically has a loan term of 10 years, while real estate usually has a loan term of 20 or 25 years.
You’ll negotiate the bank loan terms with your bank, but the term needs to be at least seven years for a machinery or equipment loan and at least 10 years for a real estate loan.
A benefit of participating in the SBA 504 loan program is that the SBA-backed portion of the financing usually comes with below-market interest rates. These interest rates are fixed over the life of the loan and usually correlate with the interest rate for five- and 10-year U.S. treasury bonds. Here are effective interest rates as of March 18, 2020:
- 10-year terms: 2.85%-3.88%
- 20-year terms: 2.81%-4.00%
- 25-year terms: 2.88%-3.71%
The loan from a bank or credit union can come with fixed or variable interest rates, though there is an interest rate cap.
There are a number of fees that CDCs may charge, so it’s a good idea to ask for a breakdown. These fees may include:
- Processing (packaging) fee: Up to 1.5% of the CDC loan amount
- Closing fee: A maximum of $2,500
- Servicing fee: Minimum annual fee of 0.625% ranging to maximum annual fee of 2%
- Late fees: The greater of 5% of the late payment or $100
- Assumption fee: Up to 1% of the outstanding principal balance on the CDC loan
- Underwriter fee: Upfront fee of 0.4% for 20- and 25-year loans and 0.375% for 10-year loans
The bank or credit union that you use for the other loan will have its own fees that you’ll want to review before taking out a loan as well.
Who is eligible for an SBA 504 loan?
Before you can qualify for an SBA loan, there are some CDC/504 loan program eligibility requirements that you’ll need to meet. Specifically, you must:
- Operate as a for-profit business (passive or speculative businesses are not allowed)
- Fall within the size standards set by the SBA
- Have a tangible net worth of $15 million or less
- Have an annual net income of $5 million or less for the two years prior to application
- Borrow money for an approved use (see more below)
- Meet job creation and retention requirements
- Demonstrate a need for the loan (i.e., demonstrate that you would have trouble qualifying for a loan without a federal government guarantee)
A requirement that may be challenging for business owners to meet is job creation and retention. To qualify for an SBA 504 loan, a business must create or retain one job for every $75,000 of the CDC portion of the loan ($85,000 for borrowers in special areas of significance like empowerment zones or $120,000 for small manufacturing borrowers). You’ll need to create these jobs within two years of the program’s completion.
If you anticipate that creating jobs is going to be difficult, there are other community development, public policy or energy reduction goals that you can meet instead. The SBA defines these goals as:
- Improving, diversifying or stabilizing the local economy
- Stimulating other business development
- Bringing new income into the community
- Assisting manufacturing firms or businesses in Labor Surplus Areas
- Revitalizing a business district of a community with a written revitalization or redevelopment plan
- Expanding exports
- Expanding small businesses development for businesses owned and controlled by women, veterans or minorities
- Aiding rural development
- Increasing productivity and competitiveness
- Modernizing or upgrading facilities to meet health, safety and environmental requirements
- Assisting businesses in or moving to areas affected by federal budget reductions
- Reducing rates of unemployment in Labor Surplus Areas determined by the Secretary of Labor
- Reducing energy consumption by at least 10%
- Increasing use of sustainable design
- Planning equipment and process upgrades or renewable energy sources
Approved uses for SBA 504 loan funds
SBA loans can be used to purchase fixed assets, including:
- The purchase of an existing building, land or land improvements (grading, street improvements, utilities, landscaping and parking lots)
- The construction of new facilities or modernization, renovation or conversion of existing facilities
- The purchase of new machinery, with a useful life of at least 10 years
- The refinancing of debt that was used for building new facilities, renovating existing facilities or buying machinery
If you’re planning to lease part of the building that you purchased or built with the loan proceeds, the SBA has rules about how much of the building must be owner-occupied. A borrower who purchases an existing building needs to occupy at least 51% of the building. For new buildings, the borrower needs to occupy at least 60% of the building, with the goal of occupying at least 80% of the building in the next 10 years.
Note that you can’t use SBA 504 loan funds for working capital, inventory or consolidating or repaying debt.
How to get an SBA 504 loan
If you’re ready to apply, remember that there are two lenders you’ll need to work with: a CDC and a third-party lender, like a bank. You can start the process by contacting either a CDC lender or a third-party lender.
You can use Lender Match on the SBA website to help you find an SBA-approved CDC lender that can get you started on the process. Alternatively, many borrowers start the process by inquiring with a commercial lender about a loan. From there, the lender refers borrowers to the SBA 504 program and a CDC lender that can assist with the process.
When you apply for the loan, you’ll be required to submit a number of documents to the CDC as a part of your loan application, including:
- An analysis of the applicant’s pro-forma balance sheet
- An analysis of repayment ability
- Financial statements with trends and industry comparisons
- A discussion of the owner’s personal credit history and experience
The CDC will then submit this information to an SBA loan processing center. If the CDC you’re applying with is part of the Accredited Lender Program, the loan documents will go through an expedited approval process.
Expediting your application process
According to Claudia Cohen, senior vice president and director of marketing at Capital Access Group, a CDC, there are steps that borrowers can take to help speed up the loan process. Prepare now if you’re considering an SBA 504 loan.
“Go to your CPA, get your books together, have your tax returns ready to go, both personal and corporate, have your financial statements, P&L and balance sheet ready to go, so that when we ask for this, it’s easy to provide it,” Cohen said, noting that this preparation helps the preapproval process go more quickly.
The typical escrow period to expect is 60 days, though it can be longer.
SBA 504 vs. 7(a): What’s the difference?
|SBA 504 loan vs. SBA 7(a) loan|
|SBA 504 loan||SBA 7(a) loan|
|Loan amount||$5 million maximum for the SBA-guaranteed portion
($5.5 million for manufacturing and green energy projects)
|$5 million total loan amount, with an SBA guarantee maximum of $3.75 million|
|Terms||10, 20 or 25 years||Five to 25 years; most loans are limited to 10 years aside from real estate and construction loans (up to 25 years) and working capital loans (seven years)|
|Interest rate||Fixed, below-market interest rate||Fixed or variable interest rate; maximum rate set by SBA depending on loan amount and term, and pegged to the prime rate|
|Fees||Processing fee, servicing fee, closing fee, late fees, assumption fee, underwriter fee||Guarantee fees and prepayment penalties|
|Eligible uses||Used to purchase fixed assets like buildings, land or machinery||Used for working capital, equipment acquisition, debt refinancing, changes in ownership or real estate purchases|
The SBA 7(a) loan program is a larger loan program that offers greater flexibility to borrowers. Like the 504 loan, the SBA partially guarantees loans, but the borrower only works with one commercial lender, meaning you won’t work with a CDC like you would with a 504 loan. The SBA 7(a) loan program also offers funding for many other uses beyond fixed assets, including working capital and debt refinancing.
While an SBA 504 loan is less flexible than a 7(a) loan, there are advantages to using a 504 loan if you’re purchasing fixed assets. The term length is typically much longer than a 7(a) loan, which usually has an average term length of only 10 years. The interest rate is also lower than a 7(a) loan, and it’s a fixed-rate loan. According to Manger, most of the 7(a) loans have a variable interest rate.
The 504 loan offers an affordable way for borrowers to purchase the fixed assets they need to grow their business. “If someone needs to buy a piece of property and they want a fixed rate for 25 years at a low interest rate, that really is their best option,” said Manger.