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Tip of the Week
Comparing Pre Payment Penalties or Premiums Between
SBA 7(a) and 504
Most bankers familiar with the SBA programs understand the basics of prepayment fees or penalties, often called premiums because from the investor's perspective, the fee compensates for loss of income. Borrowers typically see it as a penalty because it is a cost for early principal pay down or payoff. Historically, prepayment fees were only applicable on the 504 program but when prepay speeds accelerated several years ago in the 7(a) loan program, the industry asked SBA to reconsider their position in order to bring some stability to the secondary market at the time. SBA did yield and introduced modest prepayment penalties on long term 7(a) loans only. This week, we are comparing and contrasting the two programs once again from the perspective of the prepayment premium.
First, we think it should be said that the prepayment terms on both programs are fair and reasonable, but the better we as lenders understand the dynamics and the options, the better we can inform borrowers so that they can make sound financial decisions. Let's start with 504. There are two permanent loans in the 504 structure and the 3rd party mortgagee (1st position lender) can charge reasonable prepayment and other fees consistent with conventional guidelines. Most portfolio bank lenders do not charge prepayment penalties, so when a borrower in a 504structure wishes to pay down the principal ahead of schedule, usually it makes sense to pay down the bank loan first.
As for paying down the debenture, our friends at some of the most successful CDC's in the country tell us that prepayment fees aren't as complicated or as onerous as some might want to make it. There are a few nuances but practically speaking, here is how a prepayment fee on a
504 debenture works:
There is a prepayment penalty charged if the 504 loan is prepaid during the first half of its term. The penalty for prepayment of a 20-year debenture is equal to 100% of one year's interest (which is equal to the effective cost of funds) if the prepayment occurs in the first year of the loan, declining by 10% per year to zero after ten years. So at current rates, the "cost of funds" rate or the investor rate is approximately 4.660% (the effective rate to the borrower is higher due to the addition of fees in the program, but that is another discussion.) To calculate the fee for early prepayment, in the first year it would be the effective rate of 4.66% x the outstanding principal. The entire penalty amount goes to the investor to help compensate them for not getting the expected return on this particular investment in that year. During the second year, the penalty = cost of funds x 0.9 = 90% of 4.660 x the outstanding principal = 4.194% x the outstanding principal. The third year it drops to 80% of the cost of funds (= 3.728%) of the outstanding principal, and so on ... You can see the effective penalty drops off pretty quickly after a few years plus the principal balance is declining anyway due to normal amortization.
The penalty for prepayment of the 10-year debenture is equal to 100% of one year's interest if the prepayment occurs in the first year of the loan, declining by 20% per year to zero after five years.
In both scenarios, a borrower may be responsible for up to six months interest depending upon the timing of the prepayment and compliance with the notice provisions of the debenture. SBA 504 debentures are funded once a month and interest payments are made to the investor twice a year on the funding anniversary date The very best time for a borrower to pay off a 504 loan is the month prior to that six month anniversary date. Timing is everything when paying off a 504 loan, and you can only pay off a 504 loan once a month, on the third Thursday of the month.
This is where good communication and coaching between the bank lender, the borrower and CDC staff can alleviate a lot of pain and frustration for the borrower. Ideally this should all be discussed up front prior to make sure that the long term structure of the program really fits with the business plan of the borrower. It should also be noted that partial prepayments are not permitted (on 504 loans if the borrower wants to prepay the debenture, they must pay it off in full). Again though, often partial repayments on the first mortgage bank portion are permitted.
Prepayment fees on SBA 7(a) loans:
Prepayment fees on 7(a) loans only apply in the first 3 years of a long term loan (loans 15 years or longer). Remember, the prepayment fees on 7(a) loans are not retained by the lender but are remitted to SBA directly to help defray costs in the program. The prepayment fee is enforced if the prepayment amount exceeds 25% of the outstanding balance AND the prepayment is made within the first three years after the date of first disbursement (not approval) of the loan proceeds.
1st year, 5% of the amount of prepayment
2nd year, 3% of the amount of prepayment
3rd year, 1% of the amount of prepayment
The borrower may pay up to 25% of the balance outstanding each year and avoid a prepayment fee. The 25% is cumulative for each year. If they prepay more than 25% each year, they will owe the fee for each of the first three years. These penalty fees are payable to Colson and are reported on the 1502 form as prepayment penalty fees.
Example:
Bottom line, prepayment fees on SBA loans (both 7a and 504) are not that onerous. It is important to understand the basic rules and mechanics. Timing can be very important and good communication usually mitigates a lot of frustration and misunderstandings on these things.
Prepayment fees and the related nuances are just the "tip of the iceberg" relative to SBA lending procedures, regardless of the program. Our clients tell us we help them immensely by articulating clear procedures in detailed, easy to read policy and procedure formats. This approach can save considerable time, money and frustration in the loan process - leading to happier and more successful lender/borrower relationships. Call us for a free consultation to see if our services match up with your needs or not.
Take the right approach
Brian Burke and Karen McHugh
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