The Pros and Cons of SBA Loans
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Understanding the pros and cons of SBA loans can help you determine if they’re right for your business. SBA benefits include interest rate caps that help keep costs affordable for small business owners and an SBA guaranty, which reduces lender risk and can increase the chance of getting your loan application approved.
However, loans through the U.S. Small Business Administration typically require good credit to qualify and it may take months to receive funding after being approved. However, you can reduce time to funding to two weeks by working with a preferred lender.
What are SBA loans?
The SBA doesn’t lend directly to you — instead, loans are facilitated by SBA-approved lenders, such as traditional banks and microlending institutions. Depending on whether an institution is an SBA Preferred Lender, SBA loan applications may be subject to two approvals — first from the lending institution, then from the SBA.
“When a lender has Preferred Lender status, the lender has authority granted by SBA to make final credit decisions on SBA-guaranteed loans,” said Robert J. Blaney, SBA Arizona district director.
SBA loans include an SBA guaranty — the SBA will reimburse the lender for a percentage of the debt if you default on the loan. This guaranty reduces lender risk and can increase a small business owner’s chance of getting approved for funding.
SBA loan amounts range from $500 to $5.5 million and can fund expenses like working capital, inventory and commercial equipment. In addition, the SBA places a cap on how much interest SBA lenders can charge.
7(a) loan program
The 7(a) loan is the SBA’s flagship product. Borrowers can secure general financing of up to $5 million to cover most business purposes, such as working capital, fixed assets and purchasing real estate. The SBA guarantees up to 90% for all 7(a) loans. Repayment terms are up to 25 years, and interest rates can be fixed, up to a maximum 11.25%, or variable, up to a maximum 8%. Rates are based on a federal prime rate of 3.25%.
CDC/504 loan program
Under the 504 loan program, the SBA partners with certified development companies (CDCs) to provide up to $5.5 million to finance fixed assets, such as machinery, buildings or land. Funding for the loan comes from three entities: Up to 40% from a bank, credit union or another approved lender; 50% from the CDC (100% SBA-guaranteed); and, typically, a 10%-20% down payment from the borrower.
The repayment terms for SBA 504 loans can go up to 25 years. As for rates, the CDC portion can range from 2.231% to 2.399%, as of November 2020. Meanwhile, rates for the third-party portion have a maximum rate of 6% above the prime rate; both terms and rates can be negotiated between the third-party lender and the borrower.
SBA microloans offer smaller loan amounts of up to $50,000 and target borrowers from underserved markets, such as women, minorities and those with lower incomes. Microloans can cover a wide range of purposes, including working capital and machinery. You are required to repay the loan within seven years, with interest rates generally ranging between 7% and 9%.
Disaster loan program
The SBA offers disaster loans for businesses during emergencies, such as a declared federal disaster or economic injury. Unlike other SBA loans that partner with lending institutions, certain disaster loan programs are funded directly through the SBA.
- EIDL: Business owners affected by the coronavirus pandemic can obtain up to six months of working capital for daily expenses like payroll and accounts payable. EIDLs offer a 30-year repayment term and up to a 3.75% interest rate.
- PPP: This loan program helps business owners by covering payroll costs during the coronavirus pandemic. The SBA closed applications in August 2020, but Congress passed a bill to reopen the program in December 2020.
Pros and cons of SBA loans
SBA loans are generally attractive to small business owners because of their guaranties and interest rate caps. However, drawbacks include long loan closing processes and collateral requirements.
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. To qualify for an SBA loan, businesses must meet the following eligibility requirements:
- Registered and legal for-profit enterprise
- Physically located and operating in the United States or a U.S. territory
- Borrower has invested their own time and/or money in the business
- Borrower has been unable to acquire funding from another financing institution
Some loans may require businesses to meet SBA size standards, which vary by industry and are based on the business’s annual revenue or number of employees.
Businesses typically not approved for traditional loans could qualify. SBA loans include SBA guaranties, which means the lender can recover a portion of the outstanding balance if you default on your loan. This safety net reduces the lender’s risk and could lead to application approval for a borrower who may not otherwise qualify.
Lenders may also be more open to longer repayment terms. The lower monthly payment amount lessens the strain on cash flow, making it easier for borrowers to repay their loans.
Capped interest rates. Interest rates on SBA loans are comprised of a base rate plus an additional percentage by the lender. The base rate is typically based on the prime rate, LIBOR or the optional peg rate, and it can change over time. Interest rates are subject to SBA maximums, which helps to keep SBA loans affordable for borrowers.
Small and large loan amounts offered. From $500 to $5.5 million, borrowers can secure funding for both minor and major expenses. As you learn about each loan program, be mindful of their respective restrictions. For example, you may obtain a CDC/504 loan of $5.5 million, but this money can only finance fixed assets.
Resource centers available to provide assistance. The SBA offers resource centers that can provide business owners with general business assistance, SBA loan information and additional support for underserved communities. These resource centers can also assist with preparing the necessary paperwork when applying for your business loan.
SBA resource centers include:
- Small Business Development Centers: Provides management assistance to small business owners.
- Women’s Business Centers: Advocates for creating additional opportunities for women and other minority business owners.
- SCORE: Non-profit dedicated to helping businesses launch and succeed.
Cons of SBA loans
Borrowers typically must make a down payment. You can expect to make a 10% to 20% down payment to secure an SBA loan, in most cases. Lenders are more likely to work with borrowers who are willing to invest equity in their business. However, SBA-guaranteed loans still generally have lower down payment requirements than conventional loans, according to Blaney.
Collateral could be required. Many SBA lenders will require borrowers to pledge assets as collateral. Though the SBA guaranty reduces risk, the lender may still require collateral and a personal guaranty from the borrower.
The 7(a) loan, for example, may require collateral for loans of more than $350,000. For 504 loans, the fixed asset being financed will typically serve as collateral.
Personal liability if the business defaults. You’ll be legally responsible for repaying the debt in full and the lender has the right to seize any collateral you pledged if the loan defaults. If you still do not repay your outstanding balance, the SBA can send your debt to the U.S. Treasury Department for collections.
Slow approval process. The loan application process can sometimes take over two months. When researching SBA loans, borrowers can consult their local SBA district office to be connected with the right loan program and SBA-approved lender. After the lender approves the application, they must then submit it to the SBA for a second approval, which lengthens the wait.
To save time, Blaney recommended working with a preferred lender with delegated authority. “If they [the lender] use delegated authority, they generally receive the SBA approval instantly,” he said. “While there is no guaranteed timeline, generally speaking, borrowers report completing the full process in anywhere from two weeks to one month.”
Low-credit applicants are typically not approved. Lenders are unlikely to lend to a borrower with a low credit score. Interested borrowers should strive for a personal FICO Score of at least 680 before submitting an SBA loan application.
Alternatives to SBA financing
If you decide that the terms of a small business loan from the SBA don’t suit your needs, consider these alternative financing options:
The rise of nonbank and online lenders has led to financing options outside traditional banks and government entities, especially for those seeking fast funding. Alternative lenders offer various financing products, including lines of credit and merchant cash advances. However, alternative lending products often carry high interest rates and less flexible repayment terms.
Business credit cards
Business credit cards are ideal for business owners with a minimal operating history. If you were previously declined for a loan for insufficient credit, a business credit card could help you build your business credit score. In addition, business credit cards frequently offer various incentives, such as rewards on travel, dining and gas purchases.
Small business owners may start crowdfunding campaigns to raise funds from a large number of people. Since you’ll likely need to market your campaign to raise funds, those with marketing skills and an existing online following are more likely to find success with crowdfunding.
Depending on which platform you use, there often isn’t a minimum time in business or credit score requirement to starting a crowdfunding campaign. While crowdfunding sites typically don’t require you to repay the funds you raise, some crowdfunding platforms may collect a fee that’s a percentage of the total funds raised.