26 Hoosier Banker July 2015 In working with banks and borrowers, one of the biggest myths we have to debunk is the one surrounding the prepayment penalty for SBA 504 loans. Here’s a quick review: Myth: Many people mistakenly believe that the prepayment penalty for a 20-year 504 loan is 10 percent of the outstanding balance in Year One, 9 percent in Year Two, and so on until in Year 11, when the prepayment penalty is zero. Using this method, a $400,000 504 loan, having been paid down to $327,000 in Year Five, would incur a prepayment penalty of $19,620 ($327,000 × 6 percent). Reality: The truth is that the 504 program uses the 20-year note rate as the multiplier versus 10 percent, significantly reducing the prepayment penalty. In our example above, utilizing the April 2015 note rate of 2.51 percent (reducing it by 10 percent per year), the penalty in Year Five would be $4,937 ($327,000 × 1.51 percent), a substantial difference. The same reality holds true for a 10-year 504 loan. The prepayment penalty is not 10 percent in Year One, 8 percent in Year Two, and so on until in Year Six; again, the penalty is zero. The penalty multiplier is the 10year note rate in Year One (for April 2015: 1.95 percent) multiplied by the outstanding balance and then, in Year Two, the penalty is the note rate less 20 percent times the outstanding balance. Why is there a prepayment penalty? 504 loans are funded through the sale of bonds (debentures) that are backed by the U.S. government and sold to private investors. The 20-year bond is auctioned monthly, and the 10-year bimonthly. When the auction takes place, the investors are guaranteed a specific return. For example the 20-year 504 bond sold in April 2015 has a guaranteed return of 2.51 percent. To make the bondholder whole when a 504 loan pays off in the first half of the term, a prepayment penalty must be included in the payoff amount. Who receives the prepayment penalty? The investors in the 504 bond receive the prepayment penalty, so that they achieve their original stated return. How can a borrower avoid the 504 prepayment penalty? If the borrower wants to reduce its debt, yet doesn’t want to pay a 504 penalty, its bank note may allow for additional principal payments or even prepayment in full, leaving the 504 loan in place. Borrowers can also wait until the last half of the 504 loan (years 11-20 for the 20-year loan term, or years 6-10 for the 10-year loan term) when there is no penalty. A little-known fact is that a 504 loan is assumable. If your borrower sells the property (or fixed assets) and still has a 504 loan outstanding, the buyer can apply to assume the existing 504 loan. If approved, the loan is transferred to the new owner, with no prepayment penalty to the seller. Know the prepayment penalty upfront: The CDC you work with has access to a 504 calculator that can provide an estimated prepayment penalty for any 504 project. The amount will be an estimate based on the current rates, which may differ when your borrower’s 504 loan is funded. Since 504 rates have minimal variance, the estimates will be fairly accurate. t LENDING & CREDIT The SBA 504 Prepayment Penalty Myth The Small Business Administration (SBA) 504 loan program is a partnership between a certified development company (CDC) and a lender to provide permanent financing to eligible businesses for the purchase, renovation or expansion of owner-occupied commercial real estate. The 504 program can also be used for fixed equipment that has a useful life of at least 10 years. The primary mission of the 504 program is to create jobs. On a typical project, the borrower will provide a 10 percent equity injection, the lender will provide permanent financing on 50 percent of the project, and the remaining 40 percent is provided by the 504 program. 504 Basics About the Author David Amick has been serving since 1994 as executive director of Premier Capital, Indianapolis, a certified development company serving the state of Indiana. Amick has 34 years of experience in the financial services industry, serving in various capacities at commercial banking institutions. Additionally he is a director of The National Association of Development Companies, as well as a board member of several other community organizations. The author can be reached at 317-613-3504, email: damick@504partner.com. Premier Capital is an associate member of the Indiana Bankers Association.
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