How Does the SBA 504 Loan Program Work?

By Eric Reed

The Small Business Administration’s most significant function is to help small businesses secure funding. Often this comes in the form of startup capital for someone looking to create a business. However, a small business can also use SBA loans to expand, buy equipment or even open up a new location.

One such loan is the SBA 504, a low-collateral loan that is guaranteed by the SBA and meant exclusively for businesses with 500 or fewer employees. Like many of the SBA’s lending programs, 504 loans may be valuable to business owners struggling in the face of the coronavirus pandemic. 

The SBA helps entrepreneurs find money by encouraging liquidity in the lending market. It does this by backing loans made by third-party lenders on a wide variety of terms. When a small business takes out an SBA loan, it is actually taking out a loan from a bank, credit union or other third party lender. The SBA will guarantee that loan based on terms defined by the individual program the small business applied for. The lender extends the loan based on terms it sets, within limits established by the SBA. The borrower repays the lender.

For example, say that a small business owner applies for a standard 7(a) SBA loan worth $500,000. The owner would receive this loan from a local bank and would make payments to that bank. The borrower and lender would establish terms such as the interest rate and minimum payments between themselves, subject to caps set by the standard 7(a) loan program. The SBA would guarantee up to 75% of this loan, meaning that if our small business owner defaults the SBA will reimburse the bank for up to 75% of the defaulted loan.

Except for emergency or disaster relief, all SBA loans work this way: The bank lends and the agency backs and guarantees loans. This makes it easier for small businesses and entrepreneurs to borrow money, because they effectively have the federal government as a cosigner.

The full name of this program is the 504 Certified Development Loan Program, and it offers long-term, fixed-rate financing for small businesses. It is designed as a low-capital way for businesses to buy new real estate or heavy equipment, allowing them to expand or repair their operations without having to seriously hurt their cash flow.

These loans provide up to $5 million in lending that can be paid back over a period of between 10 and 25 years (more in some highly specific cases). The borrower cannot use this money for overhead, payroll, debt servicing, inventory or any other general operating expenses. It can only be used on major, fixed assets such as real estate or heavy equipment. Per an SBA guidance, examples of acceptable 504 loan expenses include:

• The purchase of existing buildings
• The purchase of land and land improvements, including grading, street improvements, utilities, parking lots and landscaping
• The construction of new facilities or modernizing, renovating or converting existing facilities
• The purchase of long-term machinery
• The refinancing of debt in connection with an expansion of the business through new or renovated facilities or equipment

A 504 loan is issued on a three-way split. The small business itself typically covers 10% of the project’s financing (although in some cases the SBA may require up to 20%). A third-party lender such as a bank or credit union provides 50% of the project’s financing. This loan is issued as part of the 504 financing but is not backed by an SBA guarantee and so may be subject to the bank’s independent credit and collateral requirements.

The remaining 40% of the loan is issued by what is called a Certified Development Company, or “CDC.” These are nonprofit corporations organized to work with the SBA in providing small business financing such as 504 loans. The SBA guarantees and, in some cases, may even supply this lending to the CDC.

The underlying project is collateral for this loan, which lets the SBA and the third-party lender offer more generous terms and typically makes it easier for banks to finance this loan as there is an asset securing the loan itself.

The SBA runs its 504 loan program for two reasons. The first is small business expansion. This program allows borrowers to grow their businesses more easily than they otherwise could, by providing them with the capital to buy major equipment and operating space.

The second reason for this program is to generate employment. The 504 loan program requires borrowers to certify that the loan will generate or sustain employment, either directly or indirectly. Smaller businesses must connect every $120,000 borrowed to one job, while larger businesses must do so for every $65,000 borrowed. By making it easier for businesses to construct buildings and buy heavy equipment, the 504 loan program helps to spur hiring in those underlying industries

The 504 loan program, an eight-year-old lending initiative run through the SBA, is one of a number of federal initiatives to help small businesses. The $50 billion in 504 loans has created over 2 million jobs. Typically, the SBA provides 40% of the total project costs, a participating lender covers up to 50% of the total project costs, and the borrower contributes 10% of the project costs, though under certain circumstances a borrower may be required to contribute up to 20%. Small businesses can use this money to make major purchases such as real estate and heavy equipment and expand or at least maintain their payroll.

While new programs like the Paycheck Protection Program (PPP) have gotten much of the attention during the coronavirus crisis, business owners shouldn’t forget about existing loan programs like 504 loans when considering their options.

• Many financial advisors specialize in working with business owners, and finding such an advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
• The government can help small businesses in other ways. One is the Federal Reserve’s Main Street Lending Program. Unlike many of the other coronavirus relief efforts for small businesses — the Paycheck Protection Program, Economic Injury Disaster Loans and Express Bridge Loans, for example — these programs are not connected to the SBA.

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