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SBA 504 - How a community bank can offer big bank terms

Uncategorized Jan 23, 2024

The SBA (Small Business Association) gets a bad wrap because of some additional forms to fill out and boxes that need to get checked, but the benefits of the SBA’s 504 program could mean the difference between winning a deal or losing it.  When used, the 504 program can lower a bank’s risk, lower a borrower’s interest rate, protect a bank’s net interest margin, and offer terms otherwise not possible by a community bank.  Let’s find out how to use this valuable tool.


What it is

The 504 program is a loan program offered through the Small Business Association to help the financing of small businesses.  The SBA has two overarching programs, 7a and 504 (yes, horribly named, I know).  Today, we will focus on the 504, and we will talk about 7a in a later blog post.  The main difference between the two programs is that the 7a provides a guarantee to a bank if a loss were to occur; whereas in a 504 the SBA lends a portion of a project’s costs directly to the customer.


When can it be used

The 504 program is designed for the financing of long term fixed assets such as equipment or real estate.  There are a few subprograms within the 504, but for ease of explanation, we will talk about the standard 504 loan being used to purchase a new piece of real estate.  


How does it work

In a standard 504, the purchase price of an asset is financing 50% by a bank in a 1st lien position, then 40% by SBA in a 2nd lien position, and then 10% by the owner.  The 50/40/10 breakdown is the normal structure of a 504 loan; however, the SBA does have a couple triggers when the owner equity requirement increases and the amount of SBA financing decreases.  These two instances are for special use properties and startups.  The main reason for these adjusters is to help compensate for additional risk when financing a special use property or startup.  In each instance, the equity contribution is increased by 5% and the SBA financing is reduced by 5%.  For example, if the proposed loan was to finance a special use property, the structure would be 50/35/15 since the special use property trigger increases the owner contribution by 5% and lowers the SBA financing by the same amount.  If in this example the customer was also a startup, an additional 5% adjustment would occur and the overall structure would be 50/30/20.  


Why 504s can be a valuable tool for a community banker?

Reason #1: Lowers a Bank’s Risk

One element of a 504 I hope you caught was that the bank is only financing 50% of the transaction in a 1st lien position.  This means a bank will be immediately be in a 50% Loan to Value position; so it’s risk of loss is greatly reduced because for the bank to suffer a loss, the collateral would have to sell for less than 50% of it’s purchase price or appraised value (yes, banks aren’t immune from loss, but we are very well protected).    This reduction in loss exposure will help a banker to sleep well at night, and it can result in the bank offering a lower interest rate due to the reduced risk.


Reason #2: Lowers a Customer’s Effective Interest Rate

The second reason why 504 loans can be a valuable tool to a banker is because it can help to lower the customer’s effective interest rate on the transaction.  The customer is more concerned with the total financing cost of the transaction than they are the cost of each component.  The reason this is important is because 504 rates are generally 1-2% lower than normal market rates.  When you couple in the fact that 40% of the transaction is financed by the 504, it can lower the borrower’s effective interest rate by quite a bit.  Banking is competitive, and by using this tool, you can offer your customer a competitive interest rate while protecting the rate earned by your bank.

In the below example, even though the bank is charging 8.50% on their share of the transaction, the effective rate of the transaction as a whole is 7.61% due to the impact of 504 financing 40% of the transaction at 6.50%.  


Reason #3: Offer Terms Beyond when a Community Bank can offer

Community banks use customer deposits such as checking accounts, savings accounts and certificates of deposit (CDs) to fund their loans.  These types of deposits can respond quickly to changes in market interest rates.  Due to this interest rate risk, community banks are pretty leery to offer long term fixed rates (10, 15 or 20 years) because even though the rate may result in a profit today, things can change drastically between now and maturity, and there is a risk you wished you hadn’t locked it in for so long.  Due to this, community banks will often limit the fixed period of their loans to 3, 5 or 7 years.  This often leads to friction with customers who want long term fixed rates.  One benefit of pulling in a 504 loan is that for the portion of the loan financed by the 504, the customer receives a long term fixed rate for 10, 20 or 25 years.  The reason the SBA can offer these rates whereas a community bank cannot is because SBA obtains its funding by selling bonds with identical maturities as the loans to investors.  By matching the length of the loan with the length of the bond, the SBA can offer long term fixed rates on their share.  This is a benefit to a community banker because ultimately the customer combines the bank and 504 loans when thinking about their total financing package, and due to this, we get the benefit of the long term fixed portion of the transaction even though our dollars aren’t at risk.


Reason #4: Lower down payment for the Customer

With the standard 50/40/10 structure, the down payment required of the customer is much lower than the normal 20-25% down payment requirement of traditional financing.  This can be huge for a small business because conserving capital is a major objective of all small businesses.  By limiting the amount of down payment, the borrower retains capital for other purposes or just to buffer liquidity to make sure any unforeseen events can be handled.  



Customers want to get their projects financed, and since they are mainly concerned with the total cost of their financing, using a 504 in certain projects will help a community banker to land more deals by offering lower effective rates for longer terms than typically possible all the while lowering the bank’s overall risk and protecting it’s own margins.  Win-win.


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