A step-by-step guide to making SBA payments
You may be able to save money by paying off your SBA loan early. But you can also simply increase your fees and start over with a new loan term.
For most small business owners, the time, energy, and expense of obtaining a US Small Business Administration (SBA) loan is sufficient. They then want to sit back and make payments without interruption.
For some, however, there comes a time when it makes sense to pay off the loan early. Let’s see how it works and why you might want to do it.
Why prepay an SBA loan?
The most common reason for prepayment of an SBA loan is refinancing. When I was working with SBA loans there was a cottage industry of people using an SBA loan to buy a hotel (because hospitality is often considered too risky for conventional loans) and then prepaying the loan after three to five years.
These borrowers would spend the first three years turning around the hotel business to increase cash flow. This way, when refinancing, the value of the hotel would be much higher and the debt service would be stable enough for conventional loans. They could reduce their rate by as much as three or four percentage points while still getting money from the loan to further improve the hotel or for a new purchase.
SBA loans have high interest rates, but if you had to get one because you had bad credit and can now save money with a better deal, that makes sense. There are also many business owners who are simply afraid of having debt and want to pay it off as soon as possible.
For this article, we’ll stick to the SBA 7(a) loan program, which is the most common. It has a 5-3-1 prepayment penalty, which means that if you prepay the loan in the first year, you have to apply a 5% penalty. If you do it in the second year, it’s a 3% penalty, and it’s 1% in the third year. After that, there is no penalty.
3 Considerations Before Making an SBA Prepayment
Keep these things in mind when deciding to prepay a loan.
1. What is your interest rate savings?
If you can refinance an SBA loan with a rate of 6% into a conventional loan with a rate of 4%, prepayment seems like an easy decision at first glance, but you have to pay attention to the small details:
- Costs: If your new loan has a 1% loan fee, $1,000 closing fee, $250 document preparation fee, $5,000 appraisal fee, and $400, you can quickly reduce the benefit of a lower interest rate.
- Damping Reset: The way loan amortization schedules work, payments at the start of the loan are almost all interest. As you progress through the term of the loan, each marginal payment adds a little more to the principal. This means that the earlier you refinance in the loan, the more pointlessly you waste paying interest on the last loan because you’re just starting the whole process over again.
- Balloon payment: Most conventional loans have a lump sum payment. Lenders lure you in by calculating the loan repayment as if it were a 25-year loan, but after 10 years you have to pay off the remaining balance in one large lump sum. Avoid these types of loans.
2. What will your cash position look like?
If you’re one of those business owners who wants to avoid debt and want to pay off your loan as soon as possible, be sure to consider your cash flow situation and opportunity cost. Opportunity cost is easy. If you can invest the money in paying off that loan, which has an interest rate of 6%, or in equipment, which will have a return on investment of 15% per year, you obviously have to invest in equipment.
Money is a little different. Only you know what the right amount of money is for your business. Some owners distribute everything at the end of the year. Some want to have a year’s worth of expenses on hand.
Refinancing is another story. You can probably fund all the fees, so you don’t have to worry about cash in the transaction. How much money you can get out of the property with a new loan should be part of your decision.
3. What are your new alliances?
Conventional loans will have clauses that allow the lender to call the loan (return all balance due at that time) if you break them. Covenants include annual document requirements, working capital restrictions, debt service coverage, and maybe even prevent you from taking out new loans.
SBA loans sometimes have covenants, but the SBA prohibits the lender from not repaying the loan for any reason other than nonpayment, so covenants are effectively unnecessary.
If you switch from an SBA loan to a conventional loan, you can save money, but you risk losing your freedom.
How to make an SBA prepayment
Here’s how you can repay an SBA loan.
1. Hire your new lender
If you are going to refinance, the first thing you need to do is find a new lender. The lender should take a quick look at your finances and do some back-of-the-envelope math to make sure you qualify for the new loan.
They will then send you a letter of interest. Once you have a letter of interest, you usually know what the new loan terms will be and can decide if the deal is worth it.
2. Obtain a repayment statement from your current lender
The next step is to get a repayment statement from your existing lender. SBA loan repayments are tricky. The SBA requires you to pay 21 days of interest, plus the principal balance, to repay the loan. If your repayment statement does not include the principal balance, accrued interest, and a prepayment penalty, if this is the first three years of the loan, return to the bank and ask them to complete the application through its SBA service.
3. Make payment
The last step is to make the payment. If you are repaying the loan in cash, it is as simple as transferring the money to the bank. Otherwise, you will need to close the new loan and have the title company handle the repayment.
To pay or not to pay
I don’t mind taking financial risks. My wife and I are earning fairly normal middle-class salaries, and in the next few months we will be taking out our fourth mortgage. In my mind, if you have a source of income that can pay off debt and earn more than the interest rate of other investments, I don’t see a big problem with leverage.
Of course, that’s not the end of the story. If you’re in a volatile business or have debt issues, I don’t blame you at all for trying to pay off the leverage as soon as you can or even find a new loan to reduce the debt burden of your business.