Small Business Owners: Paying Early Might be Costly!

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Wojtowicz is president of Indianapolis-based Cambridge Capital Management Corp., a loan management firm she founded in 1983. Wojtowicz is president of Indianapolis-based Cambridge Capital Management Corp., a loan management firm she founded in 1983.

Paying off a loan early; good idea or bad idea? You would seriously consider paying off your home or business loan before its expiration date -- if you had the cash -- in order to save money you would have otherwise paid in future financing costs.

But this appealing scenario may be an illusion. For some business owners -- particularly owners of small companies -- paying off loans early may be expensive in the long run.

A business owner who wants to look at refinancing existing debt, must ask several questions: Is the existing loan at a fixed rate?  Are there prepayment penalties?  What is the cost of a new loan, both in interest rate and closing costs?  Is the rate being offered a “teaser” rate that will adjust in the future? Should I use cash for other things, such as buying inventory or equipment? Or keep it as buffer?

In other words; “Which is most cost-effective; paying off my loan early or holding onto the loan?

Our company works with local bankers to make fixed-rate SBA 504 loans to Indiana companies. A recent borrower told us: “The 504 loan helped us deploy our financial assets more effectively.”

If you’ve seen the 504 in action, either as a business owner or banker, you are familiar with its key benefits. If you are considering 504 financing for the first time, you need to know these SBA 504 advantages: below market interest rate; fixed for an extended length of time (20 years for real estate purchases and construction; 10 years for  machinery and equipment) ; down payment as low as 10% which is much lower than conventional financing.

These features are mouth-watering to borrowers expanding, or opening, on a tight budget. The senior lender of a 504 loan, who usually is a local banker, is also well-protected because he or she often loans only 50% of the value of the asset being financed.  The difference is funded by a bond that is sold to institutional investors with a SBA guaranty. The bond’s guaranty is how the low rates are available to the companies that are borrowing.

So, do the benefits make a 504 loan something for a business owner to hold, or to pay off early, either with accumulated cash or through a refinance?

You should know that it is rarely advisable to spend valuable cash to pay off  low-interest debt. Cash is a vital tool to reinvest in the company or provide a cushion in case unforeseen hard times suddenly appear on the radar.

In addition, borrowers who relinquish a fixed rate for a temporarily lower one may regret their decision later when the new rate inevitably climbs. Remember, a fixed SBA 504 rate can never go up, and will likely be lower than any commercial rate for the life of the loan. 

And -- this is important -- if you have low, fixed-rate loan, you can use the reliable payment amount as an asset; a concrete figure for a specific term while the rest of your budget rises and falls (mostly rises) for salaries, the costs of sales and materials, insurance and other operating expenses.

It is always possible to refinance the bank’s first lien without disturbing the 504 loan.  The new lender simply needs to request that the SBA subordinate to the new loan, which can be accomplished by contacting our office.  The SBA wants the borrower to have the freedom to refinance the senior debt if better terms become available, but the 504 is meant to remain as a long-term benefit.

Some borrowers believe they must prepay their loan if they sell their business.  One of the attractive benefits of this program is that the loan can be assumed by a new borrower if they are credit worthy. Because the loan may be at a below market rate – this could be very attractive to a new buyer.

As with most fixed rate loans, there is a prepayment penalty on SBA 504 loans.  While not overly burdensome, it is another factor to consider when contemplating the pre-payment of a 504 loan.  There is often no reason to incur unnecessary fees to prematurely pay off or refinance debt.

The SBA 504 loan is a smart choice for many borrowers that will see them well into the future. It is important that the long-term benefits of this very wise decision are not cut short by an early pre-payment.

Wojtowicz is president of Indianapolis-based Cambridge Capital Management Corp.

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