Should You Pay Off an SBA Loan Early?

You may be able to save money by paying off your SBA loan early. But you may also just be increasing your fees and starting over with a new loan term.

For most small business owners, the time, energy, and expense of getting a U.S. Small Business Administration (SBA) loan is enough. They then want to sit back and make payments without interruption.

For some, however, there comes a time when it makes sense to pay the loan off early. Let’s go over how that works and why you may want to do it.

Why would you prepay an SBA loan?

The most common reason for SBA loan prepayment is to refinance. When I worked with SBA loans, there was a cottage industry of people who would use an SBA loan to buy a hotel (because hospitality is often considered too risky for conventional lending), and then they would prepay the loan with a refinance after three to five years.

These borrowers would spend the first three years turning around the hotel business to get the cash flow way up. That way, when they refinanced, the value of the hotel would be a lot higher and the debt service would be stable enough for conventional lending. They could reduce their rate by as many as three or four percentage points while also getting cash with the loan to further improve the hotel or put toward a new purchase.

SBA loans have high interest rates, but if you had to get one because you had bad credit and can now save money with a better deal, it makes sense. There are also plenty of business owners who simply get the heebie-jeebies from having any debt and want to pay it off as soon as possible.

For this article, we’ll stick with the SBA 7(a) loan program, which is the most common. It has a 5-3-1 prepayment penalty, which means if you prepay the loan in the first year, you have to tack on a 5% penalty. If you do it in the second year, it’s a 3% penalty, and it’s 1% in the third year. After that, there’s no penalty.

3 considerations before making an SBA prepayment

Keep these things in mind when you decide whether to prepay a loan.

1. What is your interest rate savings?

If you can refinance an SBA loan with a 6% rate into a conventional loan with a 4% rate, prepayment seems like an easy decision on its face, but you have to pay attention to the small details:

• Fees: If your new loan has a 1% loan fee, $1,000 closing fee, $250 document preparation fee, $5,000 appraisal fee, and a $400 employee bonus fee, you can quickly chip away at the advantage of a lower interest rate.
• Resetting the amortization: The way loan amortization schedules work, payments early on in the loan are almost all interest. As you move along in the loan term, each marginal payment puts a little more to principal. That means the earlier in the loan that you refinance, the more you threw away paying interest for no reason on the last loan because you’re just starting the whole process over.
• Balloon payment: Most conventional loans have a balloon payment. Lenders entice you by calculating the loan payment as if it were a 25-year loan term, but after 10 years, you have to pay the remaining balance as one big lump sum. Avoid those types of loans.

2. What will your cash position look like?

If you’re one of those business owners who wants to avoid leverage and you want to pay your loan off as soon as possible, make sure you consider your cash position and opportunity cost. Opportunity cost is easy. If you can put cash into paying off this loan, which has a 6% interest rate, or into equipment, which will have an ROI of 15% per year, you should obviously put it into the equipment.

Cash is a little different. Only you know what the right amount of cash is for your business. Some owners distribute everything at the end of the year. Some want to have a year’s worth of expenses on hand.

Refinancing is a different story. You can likely finance any fees, so you don’t need to worry about cash into the deal. The amount of cash you can pull out of the property with a new loan should be part of your decision.

3. What are your new covenants?

Conventional loans will have covenants that allow the lender to call the loan (make the whole balance due that moment) if you break them. Covenants include annual document requirements, working capital restrictions, debt service coverage, and potentially even precluding you from taking on new loans.

SBA loans sometimes have covenants, but the SBA bars the lender from defaulting the loan for any reason other than non-payment, so the covenants are effectively useless.

If you go from an SBA loan to a conventional loan, you may save money, but you could be losing freedom.

How to make an SBA prepayment

Here’s how you can pay back an SBA loan.

1. Engage your new lender

If you’re going to refinance, the first thing you need to do is find a new lender. The lender should take a quick look at your financials and do some back-of-the-envelope calculations to make sure you qualify for the new loan.

They will then send you a letter of interest. Once you have a letter of interest, you generally know what the new loan terms will be and can decide if the deal is worth it.

2. Get a payoff statement from your existing lender

The next step is getting a payoff statement from your existing lender. SBA loan payoffs are tricky. The SBA requires you to pay 21 days of interest, along with the principal balance, to pay off the loan. If your payoff statement doesn’t include the principal balance, the accrued interest, and a prepayment penalty, if it’s the first three years of the loan, go back to the bank and ask them to have their SBA department complete the request.

3. Make the payment

The final step is to make the payment. If you’re paying off the loan with cash, it’s as easy as wiring the bank the money. Otherwise, you’ll need to close the new loan and have the title company take care of the payoff.

To pay or not to pay

I don’t mind taking financial risks. My wife and I earn fairly normal middle-class salaries, and, within the next few months, will be taking on our fourth mortgage. In my mind, if you have an income source that can make the debt payment and can earn more than the interest rate in other investments, I don’t see a huge problem with leverage.

Of course, that’s not the end of the story. If you’re in a volatile business or have past issues with debt, I don’t blame you at all for trying to pay off leverage as soon as you can or even finding a new loan to reduce the debt burden on your business.