A common misconception about the 504 Loan Program is that the prepayment penalty is much higher than for conventional loans. The prepayment penalty is actually based on the loan's debenture rate and not the effective rate. We will explain the difference, as many borrowers are confused as to how the prepayment penalty is calculated. First, however, we want to address why the 504 Loan Program has a prepayment penalty.
Every 504 Loan is made in partnership with a Certified Development Corporation (CDC), the SBA, and a lender. The lender provides up to 50% of the financing, Community Business Finance provides up to 40% of the financing, and the borrower's contribution can be as low as 10%. Community Business Finance provides funding via the sale of a 10, 20 or 25-year federally insured bond (debenture) that is sold to private investors who receive a return on their investment over the life of the bond.
If a loan within the bond pool is paid off early, there needs to be additional funds to cover the return over the remaining life of the bond as the loan will not be generating any future interest income. These additional funds come from the prepayment penalty.
So how is the penalty calculated? Many people assume that the prepayment penalty is a 10% step down (10% the first year, 9% the second year, etc.), but this is not actually the case. It is the debenture rate that sets the percentage and not an arbitrary rate of 10%.
The prepayment penalty exists for half the term of the loan. Therefore, the amount of prepayment penalty would be the balance of the loan at the time of the prepayment multiplied by the prepayment penalty percentage.
For example, let's take a 20-year 504 Loan debenture for $1,000,000 on December 1, 2017 at a debenture interest rate of 2.45%. In November 2020 you have outgrown your space and plan to sell your building in order to move to a larger space. You plan to pay off the loan by December 1, 2020.
After three years, the principal balance of the $1,000,000 is now $897,415. The prepayment penalty amount is based on the debenture principal balance at the month prior to the anniversary date of the loan multiplied by the remaining debenture interest rate.
The prepayment penalty begins in year one and then declines by 1/10th of the debenture rate annually (on a 20-year debenture) for the first 10 years. In our example debenture rate of 2.45%, this means the rate is 90% of 2.45% in year two and 80% of 2.45%, etc. After year 10, the penalty is 0%:
Through December 2018 2.45% of $967,215 $23,697
Through December 2019 2.21% of $933,035 $20,620
Through December 2020 1.96% of $897,415 $17,589
Therefore, to pay off the loan in year three by the end of November 2020 is $17,589.
This is far less than the myth of 7% of the balance in year three, or $62,820.
Don't forget, the first lien portion of the loan is held by your bank. All lenders are different in how they handle any prepayment penalties, so we cannot address this. However, for all 504 Loans, the rates and procedures are the same nationwide.
For more information on the 504 Loan Program, contact our offices:
Business Development Director
800-462-1017, ext. 203
713-457-1650, ext. 201