How to choose SBA 504 loan vs 7a
The SBA 504 and 7a loan programs are the SBA’s flagship programs to support small businesses across America. Each has it’s advantages and disadvantages. We’ll walk through the differences in the two programs in this post.
But before we dive into the details here is a simple of thumb for deciding on an SBA 504 loan vs 7a.
What would you like to try to finance?
If you want finance commercial real estate (purchase, building, improvements or refinancing) then an SBA 504 loan is almost always the best option.
If you want to finance working capital, business acquisition, inventory and/or equipment then an SBA 7a loan is almost always the best option.
SBA 504 Advantages
-
- Lower Interest Rates*
- Fixed Interest Rates vs Variable Rates
- Supports larger project sizes above $5 million
- Lower SBA Guaranty Fees
- Does not require pledge of borrower personal assets**
SBA 7a Advantages
- Greater flexibility in use of funds
- Simpler structure than 504
- More start-up friendly
- Can be faster approval in some cases
*7a lenders (not the SBA) set rates they charge to borrowers. So while there are certainly examples where a 7a lender might set a lower rate than the 504 loan, the industry generally trends toward 7a lenders charging higher rates and often times significantly higher rates.
** 7a lenders sometimes require borrowers to pledge additional collateral not being financed against the 7a loan such as a personal home, rental property or other commercial property. This is not a requirement for a 7a loan but sometimes it does get included.
SBA 504 Loan vs 7a
| Feature | SBA 7(a) Loan | SBA 504 Loan | Advantage |
| Interest Rates | Variable or fixed, typically higher | Generally fixed and lower | 504 often cheaper rates |
| Fees | Higher guaranty fees | Lower fees overall | 504 more cost-effective |
| Use of Funds | Flexible: working capital, inventory, equipment, real estate, biz acquisition | Limited: fixed assets like real estate or equipment | 7(a) more flexible |
| Loan Size | Up to $5 million | No set size limit. SBA capped at $5 million but 1st mortgage has no cap. | 504 better for bigger projects |
| Down Payment | As low as 10% (sometimes less) | Typically 10%. Special use assets require 15% | Equal (7(a) potentially lower) |
| Loan Structure | Single loan from one lender | Two loans (bank + Certified Development Company) | 7(a) simpler structure |
| Working Capital | Can include working capital | Cannot be used for working capital | 7(a) includes WC |
Caution for Borrowers
Many SBA lenders will recommend a 7a loan to borrowers even when the 504 loan would be a better fit. For more information see our analysis of SBA loan rates comparing SBA 504 loan vs 7a. It’s a cautionary tale for sure.
But it all has to do with incentives. 7a loans are funded by an SBA lender like a bank or credit union but “guaranteed” by the US Government. So if a borrower defaults the US Government buys the portion of the loan back they have guaranteed. There is a large and liquid secondary market of institutional buyers (banks, hedge funds, traders . . .) who regularly buy US government guaranteed debt. If the 7a loans are priced right, they can be sold to loan buyers at a significant premium.
This creates a huge incentive for SBA lenders to fund 7a loans because they can earn extraordinairy fee income by originating loans without tying up much capital on their own balance sheet.
The 1st Mortgage note held by SBA lenders in an SBA 504 transaction have no government backing. It’s generally at no more than a 50% loan-to-value, which makes it a relatively safe loan for the lender but it doesn’t command massive fee/premium income like an SBA 7a.
The result of this incentive structure is that small business borrowers who might be better off in an SBA 504 loan end up with a higher interest rate and variable 7a loan because the SBA lender they work with will make more money by convincing the borrower to go the 7a route.
