If you think you’re ready to pay off your loan before the term is up, congratulations! You’re ready to move into the prepayment process, which will help you be free of your loan obligations ahead of schedule. With an SBA 504 loan, this is a fairly simple procedure, and we’re here to make sure you have the guidance you need.
504 loans can be repaid early and under very favorable conditions, sometimes with no penalty. About half of 504 borrowers choose this option, as it can be more favorable than conventional loans. Being a unique program, the 504 has unique prepayment conditions as well. Check with your CDC as soon as you begin considering prepayment to make sure you choose the option that suits you best.
What You Need to Know About Prepaying an SBA 504 Loan
First of all, let’s look at the easiest prepayment option. After the first half of the loan term has passed, the loan can be repaid early at no additional cost to you. That is, a 20-year loan can be repaid without penalty in the 11th year or later, and a ten-year loan can similarly be repaid without penalty after five years.
But let’s say you are thinking about prepayment in the fifth year of a 20-year loan. In that case, there are a few things you need to know. The first and most important question is how much your penalty will be.
Prepayment penalties decrease annually. For example, for a 20-year loan, the penalty is the full debenture rate (typically under 3%) on the outstanding balance in the first half of the first year of the loan. That penalty is reduced by 10% per year, calculated at six-month intervals, reaching zero after 10 years. There is no prepayment penalty for 20-year loans after the 10th year. Similarly, the penalty for 10-year loans starts at 100% of the debenture rate on the balance of the loan, and falls 20% each year to zero after five years.
In July 2017, the debenture rate was 2.98% on a 20-year 504 loan, while the interest rate was 4.76%. For 10-year loans, those rates were 2.32% and 4.48%, respectively. Thus, if your your 20-year loan funded in July and you chose to pay it off six months later, you would pay the balance due on it, plus 2.98% of that amount as a penalty. If your loan was five years old, you would pay 1.79% of the remaining balance as a prepayment penalty.What’s a Debenture Rate?
As noted, the debenture rate is considerably less than the interest rate. This is important because it means that the debenture rate is not generally discussed as much, so we will give a quick explanation of it here.
SBA 504 loans are bundled into asset-backed securities, called Development Company Participation Certificates (DCPCs), which are sold to government and institutional investors to support the 504 loan program. The debenture rate is the rate paid to them semi-annually. Your early prepayment represents a risk to those investors and the prepayment penalty partially makes up for the loss.
The debenture rate, like the loan’s interest rate, is based on the treasury rate plus the “spread,” or percentage added to that rate. The debenture rate is different from (and lower than) the interest rate because it is calculated semimonthly and does not take fees and closing costs into consideration.
How to Pay Off a 504 Loan Early
Like the penalty calculation, the procedure for prepayment is tailored to the DCPC market. As long as these simple rules are followed, you should be well on your way:
- Prepayment is in full
- TMC receives written notification of prepayment 15 days before the payoff date
- Prepayment is made by wire transfer
- Prepayment is made on the third Thursday of the month
If the borrower is selling the business, it is worth remembering that 504 loans are assumable, with the necessary approvals. Also, it’s worth noting that typically the rate on your first mortgage loan is adjustable and higher than the 504 rate, so it might be to your advantage to make additional payments on the first mortgage loan rather than pay off the 504 loan.
There are many options for early repayment of 504 loans. These options can be helpful for small business owners like you, whether you’re ready to pay off your loan early, or are just keeping it in mind as one more possibility in your financial planning. TMC Financing has been helping borrowers with their 504 loans for over 35 years. You can contact one of our 504 loan experts for experienced and personalized guidance as you prepay your 504 loan.