Substitution of real estate collateral is a servicing action that SBA lenders occasionally face when a borrower requests to release existing real estate collateral in exchange for a replacement property. A common example of this is when a guarantor wants to sell their home that is pledged as collateral on an SBA loan and purchase a new home. In navigating these types of servicing actions, Lenders must follow the current SOP 50 57, which contains clear guidance on how lenders should evaluate and document these transactions.
SBA lenders have the authority to make the decision to release and substitute real estate collateral after full disbursement of the loan. SBA requires lenders to follow prudent servicing practices and ensure that any substitution does not impair the ability to foreclose or collect on the loan. At its core, the test is whether the new collateral provides a Recoverable Value that is equal to or greater than the collateral being released. Remember that Recoverable Value is generally defined as the liquidation value of property, less the balance owed on senior liens and reasonable and recoverable costs to preserve and liquidate the collateral. Lenders must document that sufficient equity exists in the substituted collateral to continue securing the loan.
Special provisions apply when a borrower seeks to substitute a personal residence pledged as collateral. In such cases, SBA requires that equity in the new residence be at least equal to that in the old one, and that proceeds from the sale of the prior home (less senior liens and reasonable closing costs) be applied to the new residence purchase, placed in escrow (for future purchase of a new residence), or used to pay down the SBA loan. Most importantly, any release of existing liens should occur simultaneously with the recording of the replacement liens, usually through an escrow arrangement.
Applying this to a real-world example, consider a guarantor who pledged their residence as collateral for a loan but has decided to sell that home and purchase another. Under the SOP, the lender may release the lien on the guarantor’s existing residence so long as the guarantor applies all net sale proceeds toward the purchase of the new residence, ensures that the new home has equity equal to or greater than the prior home, and provides required hazard insurance (and title insurance, if required). The release of the old lien and recording of the new lien should be concurrent. If the release of the old lien must occur before the new one can be executed and/or recorded, the lender should escrow any proceeds of the sale of the original residence and take a security in the proceeds during the interim period which should be documented through an escrow agreement.
Lenders also most keep in mind that they still must review the credit underwriting in determining whether or not collateral can be substituted. The borrower should have a satisfactory credit history, up-to-date financial statements showing ability to pay obligations, and no significant increase in senior liens beyond nominal closing costs. These safeguards ensure that the substitution maintains the overall credit strength of the loan.
The bottom line: lenders should carefully document recoverable value, credit strength, and lien position before approving any substitution of collateral. Done properly, substitution can provide flexibility to borrowers while preserving the integrity of the SBA’s guaranty.
For more information on substitution of collateral under the SOP, contact Jessica Conn at jconn@starfieldsmith.com or 215-542-7070.
Comments are closed.