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SBA 504 Prepayment Penalties

by John Reichard on Tuesday, March 24, 2015 10:00 AM

One difference between the SBA 504 loan program and the other economic development loan programs through SEDA-COG is that the SBA 504 loan has a prepayment penalty.  Why is there a prepayment penalty and how much is it is the topic for today’s blog.

The reason why the SBA 504 loan has a prepayment penalty is that unlike SEDA-COG’s loans where funds are in an account and get lent, repaid, and lent back out again, the 504 loan is funded through a bond offering in which the investors receive a return on their investment over a 10 or 20-year period.  Regardless of what happens to a particular loan in that bond pool, the investors get their return.  So if a loan in the bond pool should pay off early, there needs to be additional funds (the prepayment penalty) to help with the return over the remaining life of the bond for the investors since the loan will not be generating any future interest income.

So how much is the prepayment penalty on an SBA 504 loan and how long is there a prepayment penalty?  One myth about the 504 program is that the prepayment penalty is much higher than conventional financing.  That’s not the case.  The prepayment penalty is based on the loan’s debenture rate (not the effective rate) at the time of funding.  The debenture rate for a 10-year 504 loan is based on the 5-year Treasury Note plus a spread and the 20-year 504 debenture rate is based on the 10-year Treasury Note plus a spread.   

How long is there a prepayment penalty on a 504 loan?  The prepayment penalty exists for half the term of the loan.  So for a 10-year 504 loan the prepayment penalty exists for the first five years of the loan and for a 20-year 504 loan the prepayment penalty exists for the first ten years of the loan.  The prepayment penalty goes down by 20% per year for 10-year loans and 10% per year for 20-year loans.  The amount of the prepayment penalty would be the balance of the loan at the time of prepayment multiplied by the prepayment penalty percentage.

For the bond sale in March, the 10-year debenture rate was 1.88% and the 20-year debenture rate was 2.72%.  The table below shows how the prepayment percentage is calculated for each loan.

Year

10-year SBA 504

20-year SBA 504

1

1.88%

2.72%

2

1.50%

2.45%

3

1.13%

2.18%

4

0.75%

1.90%

5

0.38%

1.63%

6

0.00%

1.36%

7

1.09%

8

0.82%

9

0.54%

10

0.27%

11

0.00%

How does that compare to prepayment penalties for conventional bank loans?  While lenders in different markets around the country might differ, in our area it is not uncommon to see a 5/4/3/2/1 prepayment penalty structure.  So all in all, the prepayment penalty on the SBA 504 loan compares very favorably with conventional financing, if not better.

One question borrowers have when contemplating paying off their SBA 504 loan early is whether the prepayment penalty can be waived.  The answer is under no circumstances can the penalty be waived.  However, typically a borrower can refinance the senior conventional loan and the SBA would subordinate to that new loan, thus allowing the borrower to keep the 504 loan rather than pay it off and avoid any prepayment penalties that might be in effect at the time.

Finally, SBA 504 loans can be assumable.  For example, if a borrower decides to sell the equipment and/or real estate that was financed with the SBA 504 loan, the buyer (assuming he qualifies) could assume the monthly payments on the loan, thus avoiding having to pay any prepayment penalties.

Prepayment Penalty
Author
John Reichard

Information related to the SBA 504 loan program for small businesses.

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