House Collateral and SBA Loans: What Small Business Owners Should Know
House Collateral and SBA Loans: What Small Business Owners Should Know
SBA loans come with their own set of pros and cons, and for borrowers with substantial home equity, one major downside is the SBA’s personal property collateral rule. Specifically, for loans exceeding $500,000, if you have 25% equity in any personal real estate—whether that’s your home or an investment property—that equity has to be used as collateral, potentially up to the full loan amount. Notably, SBA lenders are instructed to deduct 15% from the appraised value of your residential property before calculating your equity ownership ratio.
If you currently have a mortgage, that places the bank in a second lien position. And if you have both a mortgage and a Home Equity Line of Credit (HELOC), the SBA lender moves to a third lien position. It’s understandable that anything involving your home’s security raises numerous questions for prospective borrowers, especially when joint ownership with a spouse is involved.
Given the recent SBA rule changes, the surge in home prices, and the 50 basis point cut just announced by the Fed, now is an opportune time to clarify how house collateral plays into SBA loans for small business owners.
Who does the personal property collateral rule affect? This rule applies to any SBA borrower and any 20% owner of the applicant for an SBA loan. Conventional loans don’t typically require personal property collateral.
When might personal collateral be necessary? While the SBA doesn’t require equity in your home to qualify for a loan, if you have sufficient equity, an SBA lender may need to use it as collateral under certain circumstances. Importantly, the SBA doesn't require lenders to use personal property as collateral unless the borrower has at least 25% equity in the property’s fair market value. If you have less than 25% equity in your home, this article may not be especially relevant for you. However, for those with 25% equity or more, the collateral requirement applies for loans of $500,000 and above.
Can a HELOC prevent a property from being used as collateral? Any amount owed on a Home Equity Line of Credit is considered when assessing the 25% equity rule. If a property with a HELOC is used as collateral, the SBA lender would occupy the third lien position, while your mortgage is first and the HELOC is second. If you’re looking at an SBA loan over $500K and have 25% or more equity in your home, securing a HELOC could potentially reduce your available equity to below 25%, thus avoiding a junior lien from the SBA lender.
How does a house lien affect future HELOC options? Refinancing a collateralized property is possible, but cash-out refinances aren’t allowed. While you can maintain an existing HELOC, you won’t be able to secure a new one after your SBA loan is funded. If you don’t have a current HELOC and want to tap into substantial equity in the future, it’s wise to establish or at least start the HELOC process before applying for an SBA loan. This way, you may prevent your equity from falling below the 25% lien requirement, while still keeping access to funds through the HELOC when needed.
Will the lender drop the collateral when the loan is paid down? Small business owners often wonder if their lender will release a property from collateral once the loan is paid down enough that retaining it is no longer necessary. The answer largely depends on the specific loan terms and lender policies. While it's possible, it's not very probable.
Can I use securities instead of property? If your loan requires property as collateral, you may be able to replace it with securities, but only if those securities fully cover the loan amount. Keep in mind that Whole Life Cash Value and Marketable Securities can't substitute for a residence unless they fully secure the loan.
What happens if I sell a collateralized property? When selling a property that serves as collateral, you’ll need to notify the lender of the sale, sell the property, pay off the mortgage lender, and place your equity in escrow. After this, the lien will be released. If you purchase a new property, you can apply the escrowed amount towards that purchase, and the lender will take a lien on the new property. If you don’t apply the equity to another property, it must be used to reduce the SBA loan balance.
What about states with Homestead Protection? Texas offers some of the strongest homestead protections in the U.S. Under Texas law, a consensual deed of trust recorded against a homestead cannot be foreclosed upon, except for first position purchase money liens. However, if the property loses its homestead status, the enforceability of a deed of trust can become ambiguous. Due to limited foreclosure options, banks often avoid recording such liens. It's important to note that this protection applies only to the homestead property; investment properties, like rentals, do not receive this same protection and could be subject to junior liens if the SBA loan is $500,000 or more.
In contrast, California allows the foreclosure of homesteads but provides significant equity protection. The amount of protected equity varies based on the number of individuals residing at the property and their ages.
What happens if I default on the SBA loan while having a lien on my house? In a default scenario, having home equity or a Home Equity Line of Credit (HELOC) greatly influences the process. Liens on a house offer automatic security for the lender, simplifying legal proceedings by removing the need for judicial intervention. Without a lien, court involvement becomes necessary.
If there's a personal guarantee but no house lien, lenders must seek a judicial judgment to enforce repayment. For borrowers with existing mortgages or HELOCs, any new lien from the SBA loan would typically be subordinate to those prior liens—meaning the lender gets paid only when the property sells, which could be years later.
Foreclosure is often a last resort for lenders because of the associated costs and time. Typically, banks prefer to avoid this process, as it’s often not a fruitful endeavor. However, if there is substantial equity and the lender holds a lower lien position, foreclosure might still be pursued.
Conclusion
If you are reading this because you are getting a loan and want to understand more about personal property collateral rules I hope this was helpful. If you’re reading this because you already have an SBA loan and are possibly looking at a default scenario and wondering about the house, then we have a guide for you to read as soon as possible which explains the SBA loan default process and how to help preempt and navigate a loan default.
This article is authored by Darin Manis, founder of LoanBox.