House Collateral and SBA Loans: What Advisors Should Know

While SBA loans has its set of pros and cons perhaps the biggest negative of an SBA loan for those borrowers with substantial equity in their home is the SBA’s personal property collateral rule. The rule is that for loans exceeding $500,000, if a borrower possesses 25% equity in any personal real estate, including residential and investment properties, this equity must be used as collateral, up to the full loan amount. SBA lenders are instructed to deduct 15% from the appraised value of the residential property before calculating the equity ownership ratio.

So if you have a mortgage then the bank goes into second lien position. If you have a mortgage and a HELOC then the SBA lender goes into third lien position. Obviously anything dealing with the security of one’s home generates a lot of questions from prospective borrowers. The concern and quantity of questions is typically magnified when the advisor has a spouse who jointly owns the personal property.

With the recent SBA rule changes combined with the recent surge in home prices (and equity owned), and 50 basis points cut the Fed just announced, we thought it would be a good time to update the how house collateral works with an SBA loan.

Who do the personal property collateral rules apply?
They apply to any SBA borrower and 20% owner of the applicant of an SBA loan. Conventional loans do not require personal property collateral as a standard policy.

When is personal collateral potentially required?
The SBA doesn't require borrowers to have equity in a house or property to qualify. However, if enough equity exists, an SBA lender may be required to use it as collateral under certain conditions. Specifically, the SBA doesn't mandate lenders to use personal property as collateral if the borrower has less than 25% equity in its fair market value. If you have less than 25% equity in your home then there may be no reason for you to continue reading this article. However if you have 25% equity or more then you are subject to the collateral requirement for loans $500,000 and above.

Will a HELOC prevent a property from being collateral?
Any amount in a Home Equity Line of Credit (HELOC) is deducted from the 25% equity rule. If a property with a HELOC is used as collateral, the SBA lender would be in third lien position, with the mortgage in first and the HELOC in second. If considering an SBA loan over $500K and having 25% or more equity in your home, securing a HELOC potentially may reduce the available equity to below 25%, thereby avoiding a junior lien from the SBA lender.

How would a house lien impact the ability for a future HELOC?
Refinancing a collateralized house is possible, but cash-out refinances are not allowed. While you can maintain an existing HELOC, obtaining a new HELOC after the SBA loan is funded is not an option. If you do not have a current HELOC and have a substantial amount of equity that you would like to be able to access in the future then get this in place or at least started prior to applying for an SBA loan. You may be in a position where your HELOC won’t bring your equity below 25% lien requirement but you would still have access to the HELOC vs having a lien without being able to access any equity in the future if needed.

Will the lender drop the collateral when the loan is paid down?
Borrowers often ask if the bank will release a property from collateral once the loan is paid down to a point where retaining it is no longer necessary. The answer depends on the specific loan terms and lender policies. We put it into the it’s possible but not probable category.

Can I use securities instead of property?
If property is required as collateral, you may replace it with securities only if they fully cover the loan amount. 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?
The process involves notifying the lender of the sale, selling the house, paying off the mortgage lender, and placing your equity in escrow, after which the lien is released. When you purchase a new house or property, the escrowed amount can be applied to the purchase, and the lender will take a lien on the new property. If the equity isn't applied to another property, it must be used to reduce the SBA loan balance.

What about states with Homestead Protection?
Texas Homestead Protection: Texas offers some of the most robust homestead protections in the United States. Under Texas law, a consensual deed of trust recorded against a homestead cannot be foreclosed upon, with the exception of first position purchase money liens. While Texas law is ambiguous regarding the enforceability of a deed of trust if the property loses its homestead status, banks often choose not to record such liens due to the limited foreclosure options.

Texas is the only state treated this way. Texan advisors should take note that the homestead protection does only apply to the homestead property and investment properties like rental properties you have to not receive this protection. These properties with 25% equity will be subject to a junior lien if the SBA loan is $500,000 or more.

While California doesn’t have the same immunity as Texas provides since California law allows for the foreclosure of homesteads, but it also 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 loan default scenario the presence of home equity or a Home Equity Line of Credit (HELOC) significantly affects the process. Liens on a house provide automatic security for the lender, streamlining legal proceedings for them by eliminating the need for judicial intervention. However, in the absence of a lien, the court's involvement becomes necessary.

In situations where a personal guarantee exists but no house lien is present, lenders must seek judicial judgment to enforce repayment. For borrowers with existing mortgages or HELOCs, any new lien established from the SBA loan would generally be subordinate to these prior liens. This means that the lender is entitled to payment only when the property is sold, often many years later.

Pursuing foreclosure is often a last resort for lenders due to the associated costs and time. Foreclosure is typically an unfruitful endeavor for lenders, not a preferred outcome, and banks typically want to avoid this process. However, in cases where there is substantial equity and the lender holds a lower lien position, actions like foreclosure might be pursued.

How common is it for an advisor to lose their house because of an SBA loan default?
It is so uncommon I don’t believe it has ever happened. While this isn’t an easily trackable analytic metric, in the case of advisors it kind of is. Personal property is not required for loans over $500K now but prior to recent changes the amount was $350K. In the last 25 years there have been 1,125 SBA loans over $350,000 funded to advisors. Of this group of loans the average loan size is $1.2M if interested. There have only 4 advisor SBA loan defaults leading to a bank charge-off have been recorded. One of these SBA loans defaulted in 2013 and the other three prior to 2010. It’s doubtful all four (and we don’t know if any) even had personal property attached to those loans.

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.