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The Pros and Cons of Small Business Administration (SBA) Business Loans

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For business owners who need help funding their venture, loans from the U.S. Small Business Administration can be a popular financing option.

The SBA aims to help small business owners who have trouble qualifying for traditional business financing, said Terri Denison, SBA Georgia district director. However, that doesn’t mean everyone with less-than-perfect credit can receive SBA loans.

“What we’re looking for is that middle section — the borrower that has a good, solid business plan and idea, but maybe there’s something that’s not quite meeting all the requirements of a lender’s conventional loan,” Denison said.

If you fit that description, keep reading to explore the pros and cons of SBA loans. We’ll dive into the benefits of an SBA loan, as well as some downsides you could expect.

What are SBA loans?

The SBA doesn’t directly lend to small business owners — rather, it backs loans made through partnering lenders, including banks, community development organizations and microlending institutions. An SBA guarantee reduces risk for the lender and makes it easier for small business owners to secure financing.

Loans are available from $500 to $5 million. They can be used to cover working capital needs — such as export loans and revolving credit — or fixed assets — such as real estate and equipment. The SBA sets a cap on interest rates (more information below) to limit the amount borrowers must pay back.

There are two approval processes that occur before lenders issue SBA loans, according to Denison. First, the lender needs to approve the business owner’s loan application. Then, the lender needs to apply for a guarantee from the SBA. A lender could receive preferred status based on its past experiences issuing SBA loans. With an SBA-preferred lender, such as Live Oak Bank, loans are likely to be faster, though they may still be held up by other factors.

“We have delegated them with the authority to apply the guarantee themselves,” Denison said. “That does streamline the process considerably.”

SBA loans are offered through the following programs.

7(a) loan program

The 7(a) program is the SBA’s primary program providing general financing to small business owners. The maximum loan amount is $5 million. The SBA could guarantee 85% of loans up to $150,00 and 75% of loans exceeding $150,000. Express loans and loans for export businesses are also available, though the maximum amount and SBA guarantee percentage may differ for those loans. Repayment terms typically span seven to 25 years for standard 7(a) loans. The maximum interest rate for fixed-rate 7(a) loans is 12.81%. The maximum for variable-rate loans is the prime rate — 5.25% as of Aug. 25, 2019 — plus 4.75%.

CDC/504 loan program

The SBA certifies and regulates Certified Development Companies, nonprofits that promote economic development. A CDC/504 loan is composed of 40% of SBA-guaranteed funds, 50% from a CDC and 10% from the borrower. Business owners can use CDC/504 loans to finance fixed assets such as existing buildings, land purchases, construction of new facilities and long-term machinery, or to refinance debt from a business expansion or renovation. There is no limit on the size of a CDC/504 loan, although the SBA maximum is $5 million. Repayment terms could be 10 to 20 years. Interest rates are determined when the loan is issued.

Microloan program

SBA microloans are available through nonprofit community-based organizations. Microloans come in small amounts up to $50,000, with maximum repayment terms of six years. Interest rates range from 6.5% to 9% for microloans. Loans are issued to women, low-income, veteran and minority business owners. Eligible business owners can use microloans to cover working capital, inventory or supplies, furniture or fixtures and machinery or equipment.

Pros and cons of SBA loans

SBA loans are often sought-after financing options, but business owners are sometimes leery of the extensive application process, Denison said. An SBA loan is known to require a lengthy application that calls for many documents, like personal financial statements, profit and loss statements for the business and income tax returns.

Online business lenders ask for less paperwork from applicants, but they usually fund smaller amounts. However, as Denison noted, if you’re looking for a sizable loan from a traditional lender, you can expect to submit the same amount of documentation that an SBA loan requires.

Beyond documentation and paperwork, here are a few other characteristics of SBA loans to consider before applying.

Pros Cons
Broad eligibility requirements Borrowers typically must make a down payment
Businesses typically not approved for traditional loans could qualify Collateral could be required
Capped interest rates Personal liability if the business defaults
Small and large loan amounts offered Slow approval process
Resource centers available to provide assistance Low-credit applicants generally not approved

Pros of SBA loans

Broad eligibility requirements: Lenders and loan programs have specific eligibility requirements. But, in general, the SBA looks for businesses that meet the following criteria:

  • Must be a for-profit business.
  • Must be located and operate in the U.S. or its territories.
  • Business owners must have invested their own time and money.
  • All other financing options have been exhausted.

Businesses typically not approved for traditional loans could qualify: SBA loans could be an accessible financing option for business owners; an SBA guarantee lessens the amount lenders could lose, which could make them more willing to consider a broader range of businesses. With the SBA securing part of the loan, according to  Denison, a lender may reconsider approving businesses it would otherwise decline, such as a business with little history. Lenders typically want to see at least two to three years’ worth of tax returns from applicants, though she noted that in the last few years, one-third of approved SBA borrowers nationwide had less than two years in business.

Capped interest rates. Interest rates on SBA loans are made up of a base rate and an allowable spread, which is the percentage the lender can add to the base rate. The SBA sets a limit on allowable spreads to prevent lenders from setting the interest rate too high: for example, the allowable spread for fixed-rate 7(a) loans of $250,000 or less is 6%. The base rate — based on the prime rate, the London Interbank Offered Rate or the Optional Peg Rate — is subject to change.

Small and large loan amounts offered. SBA loan amounts range from $500 to $5 million, meaning you could secure funding for minor or major expenses. Most SBA loans can be used for any business purpose, though some  restrict how you could use the money. For instance, CDC/504 loans must be used to finance or refinance construction projects or equipment purchases.

Resource centers available to provide assistance. Small Business Development Centers in cities across the country operate in partnership with the SBA to help entrepreneurs with various aspects of business ownership, including applying for SBA loans. You could find assistance when putting together your loan application to make sure you have the best shot at approval. Other SBA-affiliated organizations, such as SCORE and Women’s Business Centers, also provide assistance and mentorship to small business owners trying to obtain an SBA loan.

Cons of SBA loans

Borrowers typically must make a down payment. The SBA doesn’t back the full amount of loans. According to Denison, even with the SBA’s guarantee, the lender would likely require you to provide 10% to 20% as a down payment. You may have to make a higher contribution for CDC/504 real estate or construction loans.

“You have to bring some investment to the table,” she said.

Collateral could be required. Although lenders are not required to take collateral to secure most SBA loans, you may need to offer assets depending on the type and size of your loan. For instance, 7(a) loans that exceed $350,000 require collateral.

If you default on the loan, the lender would liquidate your collateral and apply the value toward the remaining balance. If the collateral doesn’t cover the entire balance, the SBA would reimburse the lender for the leftover amount, Denison said.

You’re not off the hook if you default. Any business owners with a share of 20% or more must provide an unlimited personal guarantee when securing an SBA loan. The guarantee makes you personally responsible to repay the loan if the business defaults, and your personal credit could be negatively impacted.

Both the SBA and the lender could place a lien on your business or personal assets to further secure the loan, and the SBA could seize your assets to recoup costs if your business defaults, according to Denison. There may be an opportunity to negotiate a price to remove the liens, but it wouldn’t negate the effects of failing to fully repay an SBA loan.

“Even if the borrower pays the agreed price, there is still a loss to the government, which could preclude you from receiving other federal assistance,” she said.

Slow approval process. After applying for an SBA loan, it could be a while before you receive funds. It takes the SBA a few weeks to approve a guarantee for a lender, and the time frame could be longer if the deal is more complex, Denison said. The application and approval process could take as many as two to three months.

Low-credit applicants typically not approved. Although the SBA caters to business owners who have trouble qualifying for traditional financing, credit scores are still a determining factor in the application process. Poor-credit applicants generally cannot receive SBA financing, Denison said. Business owners with a personal FICO Score of 680 or higher would have a greater chance of being approved for a loan.

The bottom line

For business owners who don’t meet the requirements to qualify for traditional financing, SBA loans could provide reprieve. SBA loans are designed for borrowers who have trouble obtaining business financing. Though loans are issued through a lending institution, the SBA guarantees a portion of each loan, which reduces the risk for the lender.

The SBA also limits the amount of interest lenders can charge, which prevents borrowers from paying an extreme price for financing. Repayment terms can be lengthy, often spanning several years depending on the type of loan and loan amount you obtain. The potential to receive favorable rates and terms makes SBA loans an appealing financing option for many small business owners.

Be aware that the SBA requires a personal guarantee and may place liens on your assets to recoup losses if you default on your loan. If you can’t pay back what you borrow, you would be at risk of losing the rights to your business or personal property. As with any loan, be sure your business is profitable enough to repay your debt, including interest.

“My advice: If at all possible, pay off the obligation in its entirety,” Denison said. “You don’t want to have a loss.”

 

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