In March, the U.S. Small Business Administration (SBA) announced immediate deferment of principal and interest payments for existing COVID Economic Injury Disaster Loans (EIDL). This increases the amount of time from inception on all approved COVID EIDL loans to 30 months. The SBA hopes that the extended deferment period will provide small business owners with additional flexibility, especially those in “hard-hit” sectors, as well as those heavily impacted by current inflation and supply chain challenges.
The Kaplan CFO Perspective on Utilizing the 6-Month EIDL Payment Deferral
Generally, this deferral option by the SBA is a good thing. It means businesses do not have to begin making payment on its 30-year loan until 2.5 years after receiving the funds. However, it’s important to understand a few things:
- This is a fixed rate loan for 30 years (in actuality, 32.5 years) at 3.75% interest.
- Interest accrues over the 2.5-year deferral period, which means that the amount owed at the beginning of the deferral period will be about 10% greater than the original loan amount if you wait the full 30-months to initiate payments.
- The SBA has required businesses to pledge all their assets and even personal real estate for these loans.
- EIDL loans will affect the loan covenants that your business has with its current bank (or other senior lender).
These details certainly raise a few questions for our business owners:
- When should you begin paying off your loan?
- And how fast should you pay it off?
When should you begin paying off your EIDL loan?
We advise you pay off this loan as soon as you can, with respect to your current cash flow situation. If your business cash flow is tight, and you think an extra six-month reprieve will allow some breathing room, then wait until the end of the deferral period. However, if you can handle these payments now, it may be best to initiate those payments, under the mindset that the quicker you begin, the quicker you finish.
We understand the argument that you are getting inexpensive money (at a 3.75% interest rate); which probably isn’t feasible with a bank loan. But let’s remember that you’ve pledged your valuable assets as collateral on this debt.
How fast should you pay off your EIDL loan?
It really depends on the use of the funds. At Kaplan CFO, we are big believers in using short-term debt to finance short-term assets, and long-term debt to finance long-term assets. Allow us to elaborate:
Short-term debt (money that must be paid in a year or less) should be utilized in financing growth in receivables and inventory as “Current Assets.” Current assets are expected to be converted to cash in under a year’s time; so if you’re using the 30-year EIDL loan money to finance accounts receivables and inventory, we don’t see that as a healthy long-term gain. Therefore, we would think it wise to pay off the loan sooner, versus later. How much sooner? That’s a question for your Kaplan CFO or other financial advisor.
Long-term debt can and should be used for long-term assets, like real estate or equipment. Alternatively, you may have borrowed money during the recession just to keep your business afloat. However, the EIDL loan cannot be used to refinance old debt unless shareholders or principals of the business lent the business money on an interim basis.
One of the things to consider is if you have a bank loan, it’s likely that you pledged your business assets as collateral for that bank loan prior to receiving the EIDL loan. This means that the SBA’s collateral position is below that of your bank. You may have heard this referenced as a “junior position.” If you want to change banks in the future, the successor bank will not be in a “senior position” with respect to your collateral, as its position will fall behind the SBA. As the successor bank likely would not agree to be subordinate to the SBA’s collateral claim, this might prevent you from changing banks altogether. An alternative solution might be to request the SBA sign a subordination agreement. It is quite possible that the SBA would execute a subordination agreement, it could be a very cumbersome process.