What are the Main Differences Between an SBA Loan and Commercial Loan?
Two of the most common forms of business lending are commercial loans and United States government-backed Small Business Administration (SBA) loans. While both types of loans function similarly, there are key differences between them that can make one or the other a clear choice for any business owner.
But before we examine them in turn, remember that in many ways, a loan is a bet. By lending money to a small business owner, the financial institution is betting that they will be able to recoup that capital with interest. By looking at lending with that framework, you can see that most differentiating loan qualities and borrower criteria functions to either make sure you’re a safe bet, or to protect the lender from less safe bets. Equipment loans, for example, hold the newly-bought equipment as collateral, protecting the lender.
What are SBA Loans?
A common misconception about SBA loans is that the government itself gives out the loan. That’s not the case. SBA loans are acquired much like a commercial loan. The fundamental difference is that the US government guarantees up to 75% of the loan amount.
That guarantee acts like an insurance policy for lenders. If a business owner is unable to make the monthly payments and defaults on the loan, the government protects the lender from catastrophic loss. Think about it through the betting framework. If you were able to lose a maximum of 25% of your bet amount, wouldn’t you be more likely to place more wagers? That’s the idea behind the SBA loan program.
That’s not to say the SBA is handing out loans to anyone on the street. That guarantee is made with taxpayer dollars, and taxpayers wouldn’t stand for their hard-earned money being spent helping out financial institutions investing in substandard small businesses.
Types of SBA Loans
There are four main types of SBA loan programs, along with numerous smaller programs and subprograms. Depending on your business’s needs, any one of these loans could be a great choice.
1. The 7(a) loan program is the SBA’s most popular choice. A 7(a) loan functions much like a conventional loan: The lender provides working capital to be repaid with interest over a set term. Really the only difference is that the government protects the lender. You can borrow up to $5,000,000, and the repayment terms can last as long as 25 years.
2. The SBA CDC/504 loan program provides capital for buying commercial real estate, an occupied commercial building, or heavy equipment. These loans can be very complicated for lenders and borrowers alike, since they involve multiple financial institutions, a down payment, and two separate loans.
3. SBA Microloans average only about $13,000 and are made through non-profits. They can be used as working capital, for equipment purchases, and to buy inventory, but can’t be used for real estate.
4. Disaster Loans are the only SBA loans not specifically meant for small business owners. They’re used to help rebuild a business after a physical or economic disaster caused by something like a hurricane, flood, gas line explosion.
SBA Loan Qualifications
Regardless of which SBA loan you believe is the best fit for your small business, there are a few qualifications to keep in mind before you submit a loan application. Firstly, you’ll need a very strong credit score. Almost all SBA loans require a personal credit score above 660. Remember, SBA lenders are guaranteed only a percentage of the loan, and that guarantee is taxpayer-funded. They want assurance the borrower can repay that loan.
Each loan program comes with additional qualifications. An SBA 504 loan will require a 10% down payment on the planned purchase, as well as adherence to certain job creation criteria. Most SBA loans also require a personal guarantee, meaning the lender can seize your personal assets if you fail to make payments.
What Are Commercial Loans?
Commercial loans function in almost exactly the same way as SBA 7(a) loans, with one seismic difference: The loans aren’t guaranteed by the government. This is a massive difference. Without that safety net, there is much greater risk for lenders.
That means commercial lenders must be more strict when it comes to qualifications for borrowers. Being able to get a big commercial loan can require having a very high credit score, a polished business plan, and a personal guarantee.
But because commercial loans don’t necessarily have to fit the SBA’s exact specifications, there are definitely advantages to going after a commercial loan for your business financing. One of those advantages is that there are frankly more financing options with a non-SBA lender. You can negotiate for more flexible loan rates, longer terms, and even nontraditional repayment.
It seems simple, but you must remember that commercial loans aren’t guaranteed for lenders. So it’s in the lender’s best interest to give qualified borrowers the best possible loan terms to ensure their ability to pay. For example, if monthly payments can create cash flow issues for your business, some commercial lenders might be willing to allow annual payments. The process of applying for and receiving commercial loans will also tend to be much quicker than it is for SBA loans.
Keep in mind that a commercial lender is just that. They exist to make money. So traditional bank loans without that SBA guarantee will likely have a higher interest rate, since collecting interest is another way for a lender to protect itself against default.
How to Choose?
Both loan options can make sense for your business. If you’re looking for a quicker and less involved application process, a commercial loan may be your best choice. If you’ve got great credit and are looking for lower interest rates, you may want to work with the SBA.
As with any major financial choice, you should do extensive shopping around before you decide which type of loan is best for you and your business. You may find that a commercial loan will be fast, favorable, cheaper, and simpler. Or you may find that the SBA has a program that’s a perfect fit.
On top of all those considerations, keep in mind that you can use one type of loan to create a favorable credit history for future loans. A strong history with a short-term commercial loan now can mean a higher credit score and lower interest rates on a larger SBA loan in the future. Alternatively, good performance repaying an SBA loan now could make a commercial lender bend over backward to lend you money down the road.
What if Neither Option Works?
Every business needs something different. If you’ve determined that a traditional commercial loan or SBA loan won’t be a fit, that doesn’t mean there aren’t ideal small business loans available elsewhere. There are a variety of lenders willing to work with you. You may end up going with a more short-term loan with higher interest rates, but a higher interest rate is well worth paying if it’s the only way for your business to get to the next level.