SBA loans are an excellent source of small business funding.
SBA loans have much lower interest rates and terms compared to conventional loans. The main reason for this is because they are guaranteed by the Small Business Association.
There are currently two main types of SBA loans that can be used for small business funding.
There are currently two main types of SBA loans, SBA 7(a) loans and SBA 504 loans, which are administered and guaranteed by the Small Business Administration. Which type of SBA loan program you apply for depends on a number of factors.
The following is a list of four questions you should ask yourself to determine what type of SBA loan you should apply for.
- Are you using the loan to start a new business or purchase an existing business?
SBA 7(a) loans are more suitable for starting a new business or purchasing a business. One of the main reasons is that 7(a) loans can be used to purchase inventory and goodwill. SBA 504 loans, on the other hand, cannot be used to buy goodwill or inventory.
- Are you starting your business from scratch or do you have an existing business that needs debt financing for growth and expansion?
SBA 504 loans were mainly designed to assist existing business grow and expand.
504 loans are commonly used for the following items.
- To acquire commercial real estate, such as land and existing buildings
- To renovate or expand commercial buildings
- To landscape or put in utilities
- To purchase machinery and equipment that has an expected lifespan of 10 years or more.
SBA 7(a) loans are much more flexible than 504 loans.
SBA 7(a) loans were created mainly to help stimulate new business development. However, they can also be used for growing and expanding an existing business. The following are items that 7(a) loans can be used for.
- To purchase real estate
- To renovate or expand commercial buildings
- To landscape and install utilities
- To purchase machinery and equipment
- To buy inventory and goodwill
- To provide working capital
- How much money are you trying to borrow?
7(a) loans have a maximum loan amount of $5 million.
With 7(a) loans, the SBA will guarantee 85 percent on loans of up to $150,000 and 75 percent on loans of more than $150,000. If a business receives an SBA-guaranteed loan for $5 million, the maximum that the SBA will guarantee to the lender will be $3,750,000 or 75%.
There is no maximum regarding the total amount that can be borrowed with SBA 504 financing.
SBA 504 loans are paired with private-sector commercial loans. Since there is no upper limit to the conventional loan financing, there is no maximum regarding the total amount that can be borrowed.
With 504 loans, a certified development company (CDC) provides 40% of the total amount of the loan. A private lender provides 50%, and the borrower is usually expected to provide the remaining 10%.
Certified Development Companies (CDCs) are nonprofit corporations certified and regulated by the SBA that work with participating lenders to provide financing to small businesses. The funds provided by the CDCs are raised through a monthly auction of bonds and are 100% guaranteed by the U.S. Government.
With SBA 504 loans, there is a maximum percentage and amount of the debt financing that the SBA will guarantee.
- The Small Business Association guarantees up to 40% of a project’s costs with a maximum of $5 million in funding for standard projects.
- The SBA will guarantee 40% with a maximum of $5.5 million for green initiative business financing used and for small manufacturer projects.
- What are the collateral requirements to get the loan?
One major reason some business owners apply for an SBA 504 loan rather than a 7(a) loan is because the collateral requirements are much less for a 504 loan compared to a 7(a) loan.
With SBA 504 loans, collateral is usually limited to the project assets that are financed by the loan and other related fixed business assets. In contrast, 7(a) loans often require the borrower to put up additional assets such as inventory, accounts receivables, home equity, and other personal assets.
In general, SBA 7(a) loans are preferred over 504 loans if your capital needs are $5 million or less.
The following is a list of advantages that 7(a) loans have over 504 loans:
- SBA 7(a) loans are much more flexible than 504 loans with regards to what the loan proceeds can be used for.
An SBA 7(a) loan can be used to purchase real estate, equipment, inventory and goodwill. SBA 7(a) loan proceeds can even be used for working capital.
SBA 504 loans, on the other hand, are mainly used for acquiring or improving commercial real estate or for purchasing machinery and equipment. Any machinery or equipment that is bought with a 504 loan has to have an expected life-span of 10 years or more. A 504 loan cannot be used for purchasing goodwill, inventory or for working capital.
- SBA 7(a) loans usually have better interest rates than 504 loans.
Because the Small Business Administration guarantees up to 85% of an SBA 7(a) loan and only 40% of a SBA 504 loan, lenders are much more likely to offer a lower interest rates on 7(a) loans.
The following is a more detailed description of the SBA guarantees and how the interest rate is determined for 7(a) loans.
- The SBA guarantees 85 percent of 7(a) loans of up to $150,000 and 75 percent on loans of more than $150,000.
- You can get an SBA 7(a) loan with either a fixed or a variable interest rate.
- The actual interest rate for a 7(a) loan is negotiated between the applicant and lender. However, the SBA does set a limit to the interest rate that a lender can charge for a 7(a) loan.
The maximum interest rate on an SBA 7(a) loan is composed of the following two parts.
The base rate can either be a prime rate published in a daily national newspaper, the London Interbank One Month Prime, plus 3% or an SBA Peg Rate.
The Small Business Administration allows lenders to add an additional spread to the base rate to arrive at the final rate.
- For loans with maturities of shorter than seven years, the SBA allows a maximum spread of no more than 2.25 percent.
- The maximum spread for loans with maturities of seven years or more is 2.75 percent.
The following is a more detailed description of the SBA guarantees and how the interest rate is determined for 504 loans.
- With 504 loans, 50% of the financing is a conventional loan, 10% is provided by the borrower and 40% is guaranteed by the SBA.
The terms, the interest rates, and whether the loan has a fixed or a variable rate is totally up to the discretion of the lender regarding the private portion of 504 loan financing.
- Forty prevent of 504 financing is from a Certified Development Company (CDC) and is guaranteed by the SBA. The interest rate on SBA guaranteed portion of the loan is typically ¾ percent above the current market rate for 5-year and 10-year U.S. Treasury bonds.
- One feature of 504 loans that does decrease lender risk is that the SBA portion of the total financing is in second position. As a result, if the borrower defaults, the private lender is paid before the SBA. Because of this, the interest rates on 504 loans is almost always less than a conventional loan.
- SBA 7(a) loans usually have lower fees compared to SBA 504 loans.
The following is a more detailed description of the fees for 7(a) loans.
- On loans under $150,000, the fees for 7(a) loans are zero percent.
- On loans that are for more than $150,000 that have a maturity of one year or shorter, the fee is 0.25 percent of the guaranteed portion of the loan.
The fee jumps up to 3% for 7(a) loans with terms that are greater than one year and for $150,000 to $700,000.
- A 3.5% fee is charged on loans for more than $700,000.
- An additional 0.25% is added to the fees on the portion of the loan that exceeds $1 million.
The following is a more detailed description of the fees for SBA 504 loans.
- For an SBA 504 loan, the fees are approximately 3 percent for the 40% portion of the financing that is guaranteed by the SBA.
- The fees on the 50% portion of the financing provided by the conventional loan is totally up to the lender’s discretion and does not have a maximum amount established by the Small Business Administration.
- Unlike SBA 504 loans, SBA 7(a) loans aren’t required to meet SBA-defined policy goals.
SBA 504 loans are required by the SBA to meet certain job creation criteria or community development goals. In general, the SBA requires businesses to create or retain one job for every $65,000 provided by an SBA 504 loan. Small manufacturers have a $100,000 job creation or retention goal. These requirements are not stipulated for 7(a) loans.
How to get an SBA loan
SBA loans are dispensed by banks and other special finance companies rather than the SBA directly.
When you apply for an SBA loan, you need to understand that you don’t submit an application directly to the Small Business Administration. SBA loans are instead dispensed by banks and other special finance companies.
Previously, the main source of SBA loans for small businesses were community banks. This source of SBA loans has drastically declined as result of a large number of community banks going out of business over the last twenty years. At the same time, the large banks that now dominate the banking industry do not want to bother with small business lending.
One good trend in SBA loan financing is that non-bank SBA loan providers are rapidly filling the void in small business lending. Newtek is a good example of one of these non-bank lenders. Founded in 1994, Newtek has become the largest non-bank SBA lender in the United States. Newtek was also ranked as the 6th most active SBA 7(a) lender of all loan providers, including banks, by the SBA.