Comparing the SBA 504 and 7(a) Loan Programs

SBA 504 loan vs. 7(a) loan.

Both the SBA 504 loan and 7a loan are great financing solutions for small businesses, but they’re not created equal. Your particular business status and goals will dictate the ideal choice for your particular business. 

Compared to the SBA 504 loan, the SBA 7(a) loan is far more flexible. You can use it to fund real estate, working capital, inventory, supplies, equipment, and more. The SBA 504 loan, however, is fairly specific and designed to help small business owners purchase, lease, renovate, or improve commercial real estate, buildings, or equipment.

If you’re in need of working capital to purchase inventory or supplies or would like to fill cash flow gaps, for example, the SBA 7(a) loan is an excellent option. This is particularly true if you have collateral to provide and are looking for a faster application process. 

The SBA 504 loan, on the other hand, makes more sense if you’d like to finance real estate, buildings, or equipment and can prove you meet job creation, job retention, or public policy goals. You should also expect a slower application process.

Key differences

The table below outlines the key differences between the SBA 504 loan, the SBA 7(a) loan.

SBA 504 loans.

Formally known as the SBA 504/CDC loan, the SBA 504 loan can come in handy if you’d like to purchase fixed assets, like real estate or equipment. Its loan amounts range from $125,000 to $20 million, with terms of up to 20 years. One of the greatest perks of the SBA 504 loan is its low down payment requirements. 

Depending on your situation, you can lock in financing for as little as 10% of the asset’s purchase price. Also, while the SBA 7(a) loan offers a fixed or variable interest rate, rates for 504 loans are always fixed and never fluctuate. This makes it easy to budget for your payments in advance and avoid unwanted financial surprises. 

The 504 loan is less flexible than the SBA 7(a) loan, as it’s designed for business owners who want to improve fixed assets, like land, buildings, or equipment. These projects should encourage economic development or other public policy goals. A few examples of public policy goals include conserving energy or growing a minority- or women-owned business. 

It’s important to note that the funds from a 504 loan are not for investment properties. If you plan to finance new construction, a minimum of 60% of the building must be owner-occupied once the construction is complete and only 20% of the space can be leased in the long term. 

In most cases SBA 504 loans are self-secured so the underlying fixed assets act as collateral. 

Also, anyone who owns 20% or more of the business must sign a personal guarantee.

What are the eligibility requirements for SBA 504 loans?

For businesses aiming to secure an SBA 504 loan, several specific eligibility requirements must be met. Businesses looking to secure SBA 504 funding must operate as for-profit entities within the United States or its territories. Similar to the SBA 7(a) program, applicants must fall within the definition of a small business according to SBA size standards, which vary by industry.

The objective of the financing must align with the goals of the SBA 504 program, focusing on the purchase or improvement of fixed assets such as land, buildings, and long-term machinery. Applicants are expected to demonstrate a tangible net benefit to the community, such as job creation or retention, which should meet or exceed certain benchmarks set by the SBA.

An essential criterion is the business’s ability to repay the loan. This is evaluated through historical and projected cash flows, ensuring that the business generates sufficient income to cover loan payments and other financial obligations. A down payment typically of 10% of the project cost is required, demonstrating the borrower’s commitment and reducing the risk of default.

Furthermore, the project financed must be beneficial to the business’s operations and cannot be for passive or speculative purposes. Properties financed with a 504 loan must be at least 51% owner-occupied for existing buildings or 60% for new constructions, ensuring the primary use is for the applicant’s business activities.

Business owners seeking an SBA 504 loan must also have a sound character, evidenced by a clean criminal record and a history of responsible fiscal management. This includes no previous defaults on government loans, which would disqualify the applicant from receiving SBA assistance.

What fees and interest rates will I pay on an SBA 504 loan?

For those obtaining an SBA 504 loan, understanding the fee structure and interest rate is crucial for financial planning. The interest rates for SBA 504 loans are fixed for the life of the loan, providing a predictable monthly payment schedule. These rates are typically below market rates for commercial loans, making them an attractive option for small business owners.

In terms of fees, borrowers can expect to pay a variety of costs associated with the SBA 504 loan process. These fees include a processing fee, a funding fee, and a servicing fee, which typically total 3% of the loan amount. Additionally, there may be fees related to the third-party lending institution, legal fees, and other closing costs.

It’s important for potential borrowers to factor these fees into the overall cost of their project to ensure affordability and feasibility. Even though these fees can add up, the benefits of fixed, low interest rates and the accessibility of significant funding for major projects often outweigh the costs, making the SBA 504 loan a practical option for many small business owners looking to expand or upgrade their fixed assets.

What are SBA 504 loan collateral requirements?

The collateral requirements for an SBA 504 loan are straightforward, given its focus on fixed asset financing. Essentially, the assets being financed serve as the primary collateral. This generally includes the real estate or heavy equipment that the loan proceeds are used to purchase, renovate, or expand.

In addition to the financed assets, lenders also require personal guarantees from all principal owners of the business. A personal guarantee means that if the business fails to repay the loan, the individual guarantors may be personally responsible for the balance. This requirement is designed to ensure that those with a significant stake in the business are committed to its success and the repayment of the loan.

SBA 504 loan pros and cons.

To fully appreciate the value of SBA 504 loans, it’s important to examine both the benefits and potential downsides of this financing option.

Pros

• Low down payment: One of the most appealing aspects of SBA 504 loans is the relatively low down payment requirement, often as little as 10% of the project cost. This makes it easier for small businesses to undertake large projects without significantly impacting their cash flow.
• Fixed, below-market interest rates: SBA 504 loans come with fixed interest rates that are typically below those of commercial loans, providing predictable monthly payments and long-term savings.
• Long-term financing: With terms up to 20 years for real estate and up to 10 years for equipment, these loans offer long-term financing options, helping businesses manage their cash flow more effectively.
• Access to large amounts of capital: SBA 504 loans allow businesses to access significant amounts of capital, ranging from $125,000 to $20 million, enabling them to finance major projects.
• Economic development: The program is designed to support projects that promote economic development within a community, including job creation and retention, which can be a significant advantage for businesses with a focus on growth.
• Favorable collateral conditions: Given that the loan is typically secured by the assets being financed, businesses may not need to provide additional collateral, simplifying the lending process.
• Enhances business creditworthiness: Successfully repaying an SBA 504 loan can improve a business’s credit score, making it easier to obtain future financing.

Cons

• Restricted use of funds: Unlike SBA 7(a) loans, the use of funds from an SBA 504 loan is limited to purchasing, constructing, or improving fixed assets such as real estate and heavy machinery, reducing flexibility for other business needs.
• Complex application process: The application process for an SBA 504 loan can be cumbersome and time-consuming, requiring potential borrowers to provide extensive documentation and go through a detailed qualification procedure.
• Requires project to meet specific criteria: Projects financed with SBA 504 loans must contribute to job creation or other community development goals, which may not align with all business objectives.
• Personal guarantees required: Owners holding 20% or more of the business equity must provide personal guarantees, potentially putting personal assets at risk.
• Prepayment penalty: Borrowers face prepayment penalties if the loan is paid off before a specified period, making it costly to refinance or repay early.
• Two-loan structure can be complex: Financing typically involves both a bank loan and a CDC (Certified Development Company) loan, adding to the complexity of the borrowing and repayment process.
• Property occupancy requirements: To qualify, the financed property must be at least 51% owner-occupied for existing buildings or 61% for new constructions, which may not be feasible for all businesses.
• Not available for working capital or inventory: The SBA 504 loan cannot be used for working capital, inventory, consolidating or repaying debt, or for investment in rental real estate, limiting the scope of financial planning for some businesses.

SBA 7(a) loans.

The SBA 7(a) loan is considered the SBA’s flagship program. It’s flexible in that you can use it to cover a variety of business-related expenses, such as working capital, inventory, equipment, and real estate. The SBA 7(a) comes with loan amounts of up to $5 million with repayment terms of up to 25 years. Compared to loans from traditional lenders, like banks and credit unions, the SBA 7(a) loan offers competitive interest rates that can save you hundreds or even thousands of dollars over time. 

In most cases, the SBA 7(a) is the way to go. It’s a flexible, low-interest rate financing solution that is ideal for a number of purposes. To qualify, you must be based in the U.S. and meet the SBA’s definition of a “small business,” which depends on your industry. In addition, you’ll have to show that you’ve invested at least some of your own funds in the business and looked into other financing solutions. 

If you go this route, be prepared to pay an SBA guarantee fee, which will ensure the government has the money to reimburse the lender if you can’t repay the loan. You may also need some type of collateral. In addition, anyone who owns 20% or more of the business will be required to sign a personal guarantee.

What are the eligibility requirements for SBA 7(a) loans?

To be eligible for an SBA 7(a) loan, a business must meet several key criteria. Businesses seeking SBA 7(a) funding must operate for profit within the United States or its territories. The business should also have reasonable invested equity, ensuring that the business owner has personally invested in their venture. Additionally, the business must demonstrate a need for the loan proceeds and use them for a sound business purpose. The business cannot be in the business of lending and must not present a conflict of interest with the SBA.

Applicants must also qualify under the SBA’s definition of a small business, which varies by industry. Generally, this means meeting specific size standards related to the number of employees or annual receipts. The business must also show that it has attempted to use other financial resources, including personal assets, before applying for an SBA loan.

The credit history of both the business and its owners will be examined. This includes a review of both personal and business credit scores. Business credit scores of 155 or higher or personal credit scores of 650 or higher are typically required to receive SBA 7(a) loan funding. Applicants need to demonstrate a satisfactory ability to repay the loan from earnings, not reliant on speculative gains. All applicants are also subject to a background check which considers character, criminal history, and previous financial behavior, including any past dealings with the government such as previous loans or tax obligations.

What fees and interest rates will I pay on an SBA loan?

For SBA 7(a) loans, interest rates are typically linked to the prime rate and can be fixed or variable. These rates are often more competitive than those of traditional bank loans, providing an appealing cost-saving benefit for small business owners.

In addition to interest rates, borrowers of SBA 7(a) loans also need to be aware of various fees that can apply. One of the more significant charges is the SBA guarantee fee, which is based on the loan amount and the maturity of the loan. This fee ranges from 0% to 3.5% of the guaranteed portion of the loan, with rates adjusting based on the size of the loan and the repayment term. Additionally, there might be servicing fees, closing costs, and late fees if payments are not made on time.

Understanding these costs upfront is crucial for potential borrowers. It allows for a more accurate calculation of the total cost of the loan, ensuring that businesses can make informed financial decisions and select the loan option that best suits their needs.

What are SBA 7(a) loan collateral requirements?

While SBA 7(a) loans are renowned for their flexibility and favorable terms, potential borrowers should understand the collateral requirements that accompany these loans. Generally, for loans $50,000 or more, the SBA will require its lenders to use the established collateral policies and procedures for their similarly-sized non-SBA guaranteed commercial loans. Types of collateral may vary and can include business assets, personal assets, or both. This might encompass real estate, equipment, inventory, or personal property.

For loans under $50,000, lenders are not required by the SBA to take collateral, making the SBA 7(a) program accessible even for small-scale borrowers who might not possess extensive assets. However, for loans exceeding $350,000, the SBA mandates lenders to collateralize the loan to the maximum extent possible up to the loan amount. If the loan is not fully secured, the lender must demonstrate that the proposed collateral is indeed the maximum available and that the loan is of sound value.

It’s important for prospective borrowers to engage in open and honest discussions with their SBA-approved lender about the collateral requirements specific to their loan. Being well-prepared and clear about what assets can be used as collateral will streamline the application process and help set realistic expectations about securing an SBA 7(a) loan.

SBA 7(a) loan pros and cons.

To better understand the SBA 7(a) loan program, it is crucial to weigh its advantages and disadvantages.

Pros

• Versatility: One of the most significant advantages of the SBA 7(a) loan is its flexibility. Funds can be used for a wide range of business purposes, including working capital, debt refinancing, purchasing equipment, or buying real estate.
• Lower down payments: Compared to conventional loans, SBA 7(a) loans often require smaller down payments. This makes it easier for small businesses to access the capital they need without having to tie up too much of their liquid assets.
• Longer repayment terms: With repayment terms of up to 25 years for real estate and 10 years for equipment or working capital, businesses can benefit from lower monthly payments and improved cash flow management.
• Competitive interest rates: The SBA 7(a) loan program offers interest rates that are typically lower than those of equivalent commercial loans, reducing the cost of borrowing for small businesses.
• Available to startups: Unlike many conventional loans that require a business to have a history of profitability, SBA 7(a) loans are available to startups and new businesses, assuming they meet the eligibility requirements.
• Counseling and education: Borrowers have access to SBA resources, including counseling and education services, which can be invaluable for new and growing businesses.
• SBA guarantee: Because the SBA guarantees a portion of these loans, lenders are more willing to fund businesses that might not qualify for traditional loans, thereby increasing access to capital for small businesses.

Cons

• Complex application process: The procedure to apply for an SBA 7(a) loan can be lengthy and complex, requiring extensive documentation and potentially leading to longer wait times for approval.
• Collateral requirements: While not always required, collateral might be necessary for larger loans, posing a challenge for businesses without substantial assets.
• Personal guarantee: Owners with a 20% or greater stake in the business are often required to provide a personal guarantee, putting personal assets at risk if the business fails to repay the loan.
• SBA guarantee fee: Borrowers are subject to pay an SBA guarantee fee, which can add to the overall cost of the loan.
• Prepayment penalties: For loans with terms of 15 years or more, there may be prepayment penalties if more than 25% of the loan is paid off within the first three years.
• Qualification hurdles: The requirements to qualify can be stringent, including strong credit scores, which might exclude some businesses.
• Limited funding amounts: Although the maximum loan amount can reach up to $5 million, the actual amount granted depends on various factors, potentially limiting the funding a business can secure.

How to choose between an SBA 7(a) vs. 504 loan.

Choosing between an SBA 504 and a 7(a) loan boils down to your specific business needs, the nature of your project, and your long-term financial strategy. If your primary goal is to secure working capital, refinance business debt, or cover operational expenses, an SBA 7(a) loan offers the flexibility and versatility to support a wide range of business purposes. Its potentially larger loan amounts and the possibility to cover soft costs make it suitable for businesses seeking a more all-encompassing financial solution.

On the other hand, if your objective is to invest in fixed assets such as real estate or heavy equipment, an SBA 504 loan could be the better choice. With its low down payment requirements, fixed interest rates, and long-term repayment options, it’s designed to make sizable capital investments more affordable. Additionally, the SBA 504 loan fosters community development and encourages long-term economic growth, providing not just financial but also societal benefits.

Ultimately, the decision should be informed by a thorough analysis of your financial situation, growth forecasts, and how the loan’s terms align with your business’s cash flow and investment plans. Consulting with a financial advisor or a lending specialist can provide insights tailored to your specific circumstances, enabling you to make a well-informed choice between these two SBA loan options.

Bottom line

If you’re in the market for a flexible loan, the SBA 7(a) loan can check off all your boxes. As long as you meet the eligibility criteria, you may lock in a low rate and lengthy repayment term you might not find elsewhere. Plus, you’ll enjoy the peace of mind of knowing your loan is backed by the government. 

An SBA 504 loan can help you meet your goals if you hope to grow through new or updated facilities. You may get approved with a low down payment and secure competitive interest rates and terms for commercial real estate.

Before you choose a loan, consider the current state of your business, as well as your unique business goals and priorities. Ready to learn more about SBA loans? See if you qualify and apply for an SBA loan.