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Businesses that need cash quickly but don’t have strong credit will sometimes turn to an alternative type of funding called a merchant cash advance (MCA). With an MCA, a financing company gives you an upfront sum of cash that you repay using a percentage of your debit and credit card sales, plus a fee.

An MCA can be helpful for covering cash flow shortages or short-term expenses, but if you end up taking out more than one merchant cash advance, you can end up paying different (and potentially high) interest rates and fees for each. Plus, you have to deal with different payment schedules for each MCA.

A merchant cash advance consolidation is an option that lets you roll up all of those advance payments into one. Ideally, an MCA consolidation has the potential to reduce what you’re paying in interest and fees. Here’s what you need to know about this type of consolidation loan.

What Is a Merchant Cash Advance?

Not every business qualifies for a traditional bank loan. Perhaps it hasn’t been in business long enough to be eligible, or maybe it doesn’t meet the credit requirements for a small business loan. That’s when a merchant cash advance may be useful.

An merchant cash advance is not a loan, but rather an advance on future sales. To determine eligibility, MCA providers may not rely heavily on criteria like time in business and/or credit scores, but instead focus on revenues. That can make it easier to get than other types of financing.

How MCAs Work

When you get an MCA, you receive a lump sum payment. Typically, MCAs express the interest they charge as a factor rate (often ranging from 1.1 to 1.5) rather than as a percentage. The factor rate does not include any additional fees the merchant cash advance company may charge you, such as administrative or underwriting fees.

How MCA Repayment Works

The repayment on an MCA works differently than other types of business loans. Typically, the MCA provider automatically deducts a daily (or weekly) percentage of your debit and credit card sales until the advance is repaid in full. Repayment periods can range anywhere from three to 18 months. Generally, the more you make in credit card sales, the faster you’ll repay the advance.

The downside is that MCAs tend to have much higher fees and interest rates than traditional small business loans, making them a costly financing option.

When you convert factor rates plus fees into an annual percentage rate (APR), the APRs on merchant cash advances can run as high as 350%, depending on the lender, size of the advance, fees, business revenue, and how long it takes to repay the advance.

What Is Merchant Cash Advance Consolidation?

A small business owner might take out a merchant cash advance to see their way through a slow period. Then, when they struggle with repayments, they may apply for another MCA to help repay the first. This is a process known as loan stacking. The company could then end up with multiple repayment schedules and paying different factor rates and different amounts for each advance.

A merchant cash advance consolidation rolls multiple MCAs into a single new loan. The consolidation loan typically pays off your existing MCAs and allows you to make one payment, often monthly, to the consolidation lender. Ideally, the consolidation loan will have a lower interest rate than the average of the multiple advances.

Recommended: Loans for Sole Proprietors

Signs You Need Consolidation

Signs you need a merchant cash consolidation include:

•  Multiple MCA loans: If your business has taken out many MCAs, a consolidation loan can help you streamline your payments and possibly save money on interest.

•  High interest rates: MCAs often come with steep fees, so consolidating into a lower-rate loan could reduce overall costs.

•  Falling behind on payments: Missing or struggling with payments is a strong indicator consolidation is necessary.

However, there are a few things to consider before you jump into MCA consolidation. One is whether or not your existing MCA lenders will charge you a prepayment penalty fee if you pay off your advances early. You’ll also want to find out if there are any upfront fees you have to pay for the new consolidation loan, since this can eat into your savings.

If, after running all the numbers, it looks like you can save money and streamline repayment, it may be a good time to consider a merchant cash advance consolidation.

Recommended: How Does Debt Consolidation Work?

What to Consider Before Applying

Before applying for a consolidation loan, you’ll want to look at what you’re currently paying in interest and what you’d qualify for with a new loan. Also, consider any fees for the new loan and any payoff penalties you’ll owe your current lenders. If, once you crunch the numbers, your total debt hardly goes down, there’s probably no sense in taking on a new consolidation loan.

When deciding whether it makes sense to do an MCA consolidation, you also want to look at the repayment period and what your payments with the new loan will be. A shorter repayment period can mean larger payments that you might not be able to afford. And, while a longer repayment period can mean smaller payments, it will likely mean paying more in total interest.

Examining the options can help you find the best path forward for your business.

Potential Drawbacks and Risks

Merchant cash advance (MCA) consolidation loans can provide relief, but they come with potential drawbacks and risks, including:

•  Extending the repayment period, which potentially increases the overall interest costs.

•  Paying high fees, which could negate the benefits of combining advances.

Additionally, if you’re consolidating to manage cash flow, it could be a sign of deeper financial issues, and relying on more debt may worsen the situation.

Refinancing vs Consolidation

If you’ve heard of business loan refinancing, you may think it’s the same as merchant cash advance consolidation, but these aren’t exactly the same.

It’s true that both can potentially lower your interest rate and/or change your payment term. However, when you refinance, you’re replacing one MCA with a new one or with a small business term loan. When you opt for an MCA consolidation, you’re rolling multiple MCAs into a new MCA or other type of business loan.

Recommended: Refinancing Your Student Loans While Starting a Business

Types of Consolidation Loans

Lenders may have different approaches to help you with consolidating your loans. Some will buy out the loan and pay it off directly, while others will lend you the money, after which it’s your responsibility to pay off your existing MCAs.The following types of loans can be used to consolidate your MCAs:

Merchant Cash Advance

If you’ve taken out multiple MCAs, it’s likely because your business doesn’t have great credit and may not qualify for other types of loans. If that’s the case, you might consider a new, larger merchant cash advance to consolidate your existing MCAs, ideally with more favorable terms.

Be aware that you will likely have a short repayment period, perhaps between a few months and three years.

Online Lenders

Another consolidation option if you don’t have excellent credit is taking out a consolidation loan with an online lender. Interest rates may be lower than with a merchant cash advance and repayment terms may be longer. A longer repayment term typically means your monthly payment will be lower; however, you’ll pay more in interest overall than with a shorter repayment term.

SBA Loans

SBA loans like the 7(a) program can be used to consolidate business debt that is approved by your lender, if you qualify. Repayment terms can be up to 25 years, and rates on SBA loans are among the lowest of any financing option for businesses.

Traditional Bank Loans

If you’ve been able to build your business or personal credit since taking out the MCAs, you may qualify for a bank loan with lower rates and longer repayment terms. You can then use the proceeds of the loan to pay off your existing MCAs.

The Takeaway

If you feel like you’re drowning because you’re paying too much, too often, for multiple merchant cash advances, consolidating with a new advance or small business loan may be a solution that could help you lower your costs and roll everything up into one monthly payment.

If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.

FAQ

What is a merchant cash advance consolidation?

A merchant cash advance (MCA) consolidation combines multiple merchant cash advances into a single MCA with more manageable repayment terms. Ideally, you’ll receive better rates and terms with your new merchant cash advance.

What happens if I don’t repay my merchant cash advance?

If you don’t repay your merchant cash advance (MCA), the lender may increase withdrawal amounts, freeze business accounts, or pursue legal action. Your personal and business assets could be at risk, and your credit score could be negatively impacted. This could affect financing options down the line.

Why consolidate your merchant cash advances?

The main reason to consolidate your merchant cash advance (MCA) is to simplify your payments. Rather than making multiple payments each week or month, you’ll only have to make one. Consolidating could also reduce your interest rate, saving you money over the life of the loan.

Photo credit: iStock/ipopba

SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOSMB-Q324-040

If you’re considering taking out a business loan, you’ll want to make sure your company looks like a safe bet in the eyes of a lender. One of the metrics they may look at is your debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio.

Debt-to-EBITA is a financial metric that looks at how much of the income your business is generating is available to pay down debt before covering interest, taxes, depreciation, and amortization expenses.

Read on to learn how this ratio is calculated and how to know if your company’s debt-to-EBITDA is healthy.

What Is Debt-to-EBITDA?

Simply put, debt-to-EBITDA measures the ability of your company to pay its debts off. It compares your actual cash earnings to your financial obligations, including debt and other liabilities.

A high debt-to-EBITDA ratio might result in a lower business credit score, whereas a lower ratio could positively impact your credit profile, making it easier to qualify for financing at favorable rates and terms.

What Is EBITDA?

EBITDA stands for earnings before interest, tax, depreciation, and amortization. It is a measurement of a company’s profitability before those expenses are taken out.

While not accepted by GAAP (generally accepted accounting principles), EBITDA is often used by analysts and investors to compare the profitability of two companies in the same industry.

The reason is that EBITDA removes expenses that can vary depending on a company’s capital structure (and how much it spends on interest on debt), historical investments (which affects its depreciation and amortization expenses), and tax burden (which can vary from state to state).

You can calculate EBITDA by looking at your income statement and adding interest, tax, depreciation, and amortization back to net income.

EBITDA = Net Income + Interest + Taxes + Amortization + Depreciation

What Is Debt?

Debt is anything your company owes another company or individual and includes both short-term and long-term debt obligations. You can find these numbers in a company’s quarterly and annual financial statements.

Exactly what obligations are included in total debt for the debt-to-EBITDA ratio, however, is somewhat open to interpretation. Often, it’s defined as all interest-bearing liabilities, such as small business loans.

If you want to take on more debt, lenders may look at financial metrics like your debt-to-income ratio, debt-to-equity ratio, and your debt-to-EBITDA ratio. All of these can help a lender understand the likelihood of your being able to repay a new loan with the given amount of debt you currently have.

Formula for Calculating Debt-to-EBITDA

Calculating the debt-to-EBITDA ratio is done by dividing a company’s short-term debts and long-term debts by its EBITDA. The main goal of this ratio is to reflect the amount of cash available with the company to pay back its debts.

Debt-to-EBITDA Ratio Formula

To calculate the ratio for debt to EBITDA, you would use this formula:

Debt-to-EBITDA Ratio = Total Debt / EBITDA

What the Debt-to-EBITDA Ratio Tells You

The debt/EBITDA ratio compares a company’s total liabilities to the actual cash it is bringing in. The goal of this financial ratio is to show how capable the business is of paying its debt and other liabilities.

Generally, the lower the debt-to-EBITDA ratio, the more money your company has available to cover its financial obligations when they come due. A higher debt-to-EBITDA ratio, on the other hand, suggests that the business is heavily leveraged and might run into trouble paying upon its debts.

What’s considered a good debt-to-EBITDA ratio will vary by industry. Generally speaking, however, a ratio of 4 or 5 is considered to be high. This may be a red flag to potential investors or lenders that your business is over leveraged and could potentially default on its debts.

Uses of Debt-to-EBITDA

So when would you actually use your debt-to EBITDA ratio? If you’re looking to borrow money for your business, it can be smart to calculate your debt-to-EBITDA ratio before you get to the business loan application so you know where you stand.

If you borrow money from a bank, there may be a requirement to meet a certain debt-to-EBITDA ratio in your loan agreement. If you can’t keep that ratio, you may risk the loan being called.

If you are considering bringing on investors, they may also want to look at your debt-to-EBITDA ratio. Investors will often use this ratio to gauge the approximate amount of time it will take a company to pay off all of its debts with its available cash.

Recommended: How to Read Financial Statements

Pros and Cons of Using the Debt-to-EBITDA Ratio

There are both benefits and drawbacks to using debt-to-EBITDA ratio to assess the financial health of a business. Here’s how they stack up.

Pros

Debt-to-EBITDA is simple to calculate. Debt can be found on the balance sheet and EBITDA can be calculated from the income statement. As a result, this ratio can be a quick way to get a snapshot of a company’s financial health and liquidity.

The debt-to-EBITDA ratio is also popular with analysts because it relates the debts of a company to its business cash flow by ignoring non-cash expenses. This is important because, in the end, it’s cash, and not profits, that is needed to pay off debts.

Cons

Because EBITDA adds interest, taxes, depreciation, and amortization to net income, it may not provide an accurate measure of a firm’s actual earnings. If any of these variables are high, it could impact a company’s ability to pay debts.

In addition, debt-to-EBITDA may not be useful for comparing companies in different industries. Capital requirements vary by industry and, as a result, some companies need to carry a higher debt loan than others. For this reason, using debt-to-EBITDA to compare firms across industries may not be reliable.

Debt-To-EBITDA Ratio Example

Let’s look at an illustration of how the total debt-to-EBITDA ratio can indicate a company’s financial health (or lack thereof).

Calculation Example

Let’s say company ABC’s EBITDA is $10 million and its debts add up to $30 million. To calculate ABC’s debt-to-EBITDA ratio, you would calculate:

Debt-to-EBITDA = $30 million / $10 million

Debt-to-EBITDA = 3

A debt-to-EBITDA ratio of 3 is generally considered low and indicates that ABC has revenue to cover its debts. A lender may look at that ratio and decide ABC isn’t a risk and approve a loan.

Here’s another example: Let’s say company XYZ has an EBITDA of $10 million, but has $60 million in debt. This would be it’s ratio:

Debt-to-EBITDA = $60 million / $10 million

Debt-to-EBITDA = 6

Depending on the industry, a ratio of 6 may be considered high and could make it difficult for XYZ to get a good credit rating and qualify for any additional financing.

Recommended: A Guide to Ecommerce Business Loans

The Takeaway

The debt-to-EBITDA ratio reveals how much actual cash a company has available to cover its debt. It is one of many financial metrics used by lenders, analysts, and investors to gauge a company’s liquidity and financial health.

As a business owner, it can be a good idea to periodically calculate your company’s debt-to-EBITDA ratio. It can give you insights into your company’s current financial position and also help you see trends over time. If you see the ratio going down, for example, it means that you are paying down debt, the company’s earnings are going up, or both.

If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.

FAQ

What is considered a good debt-to-EBITDA?

A good debt-to-EBITDA ratio will depend on your industry. Generally, however, a ratio of three or less can indicate that your business has enough cash flow to comfortably cover its debts.

Is debt included in EBITDA?

Yes. EBITDA stands for earnings before interest, tax, depreciation, and amortization. Interest represents the interest your business is paying on its debts.

What does debt-to-EBITDA indicate?

The debt-to-EBITDA ratio indicates how much income you have available to pay down debt before covering interest, taxes, depreciation, and amortization expenses.

Photo credit: iStock/sanjeri

SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOSMB-Q324-038

When you start your own business, you may have trouble getting approved for traditional financing because you haven’t been in business very long or haven’t established business credit. Yet you still need capital to launch your business, renovate space, or hire employees.

An unsecured business line of credit for startups may be one option worth considering. Be aware that they usually have higher interest rates because lenders consider them riskier.

Keep reading to learn what an unsecured business line of credit is, pros and cons, and how your startup may be able to qualify for one.

What Is an Unsecured Line of Credit?

An unsecured business line of credit is a flexible form of financing that allows businesses to borrow funds as they need them. Similar to a credit card, you spend what you need (up to your credit limit), pay it back with interest, and are free to use the funds again. Unsecured lines of credit do not require collateral, such as property or equipment.

The credit limit on an unsecured line of credit is determined by the business’s creditworthiness and financial history, with interest charged only on the amount borrowed. Because startups lack an established financial history, lenders typically require strong personal credit scores, a solid business plan, and sometimes a personal guarantee to offset the risk.

Pros and Cons

An unsecured business line of credit may make it easier for startups to access funds for operational needs or growth opportunities. However, like any form of business financing, they come with pros and cons.

Pros of unsecured business lines of credit for startups include:

•  Quick access to cash

•  Interest charged only on the amount borrowed

•  No collateral required

Cons of unsecured business lines of credit for startups include:

•  May need a strong personal credit score

•  Interest rates may be higher due to lack of collateral

•  Credit line may be low

Unsecured vs Secured Business Line of Credit

The difference between secured and unsecured lines of credit is that secured business lines of credit require collateral, whereas unsecured lines do not. Collateral includes property, equipment, or inventory, which backs the loan and reduces the lender’s risk. This often results in lower interest rates, higher credit limits, and more favorable terms.

In contrast, an unsecured business line of credit doesn’t require collateral, making it more accessible for businesses without significant assets.

Recommended: Unsecured Business Loans

Requirements to Qualify

For established businesses, lenders look at credit scores, time in business, and annual revenue to qualify for an unsecured line of credit. However, startups typically do not have established revenue or a lengthy business history.

Because of that, lenders typically require a strong personal credit score since there is no collateral involved. Startups may also need to provide a solid business plan and financial projections to demonstrate the viability of the business.

Some lenders may also require a personal guarantee, meaning the business owner is personally liable for repayment. Additionally, the startup should be legally registered and in good standing, with a clear use for the credit line, such as managing operational costs.

Alternatives to Unsecured Business Line of Credit for Startups

Some startups may find it difficult to qualify for an unsecured line of credit. Here are a few other small business financing options that may be available to startups.

Business Credit Cards

Business credit cards can provide new business owners with needed access to cash. They can also be an important tool to help business owners separate their personal finances from their business finances. Credit card issuers will generally review things like your personal credit score and income. Some options may require collateral or a personal guarantee.

Recommended: Can You Get a Business Credit Card Before You Open a Business?

SBA Microloans

The U.S. Small Business Administration (SBA) has a microloan program that offers loans up to $50,000 to certain eligible small businesses. These small business microloans can be used to finance things like working capital, inventory, furniture, and machinery or equipment. Other SBA loans may also provide eligible small businesses with funding to meet their needs.

Crowdfunding

There are a variety of crowdfunding platforms online that allow business owners to raise money to support their business. This process allows business owners to raise money for their business without taking on additional debt.

Equipment Financing

Equipment financing helps businesses that are in need of new or used equipment. With this type of loan, the equipment becomes the loan collateral, which means that lending requirements may be less strict than for unsecured loans.

Recommended: Bad Credit Business Loans

An Unsecured Business Line of Credit Can Give You the Boost You Need

Having access to cash when you need it can be tremendously helpful to a startup. It can be used for business growth, managing cash flow, purchasing inventory, covering operational expenses, financing short-term projects, or addressing unexpected costs.

Keep in mind, though, that some lenders will charge more than others — whether that’s in fees, interest, or both — so it’s important to choose a lender that will offer you the best rates and terms for your situation.

Recommended: Business Loan vs. Personal Loan

The Takeaway

An unsecured business line of credit can help you fund and build your venture. The growth of many new businesses depends on their ability to access adequate capital. However, unsecured business lines of credit have higher interest rates and you may have to sign a personal guarantee, meaning you will be responsible for paying if the business fails.

If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.

FAQ

What is an unsecured line of credit for business?

An unsecured line of credit for business is a revolving credit account that a company can access and draw funds from up to a set limit. It’s a commercial lending product that does not require businesses to pledge any assets as collateral.

How do I get a $250,000 unsecured line of credit for my business?

Each lender has a different cap for lines of credit, so look around to find one that offers $250,000 or more, then review the requirements to see if you might qualify.

How do I qualify for an unsecured line of credit for small business?

Requirements vary from one lender to another, but you will likely need to meet eligibility standards like a minimum time in business. Your business may also need to generate strong annual revenues and meet a minimum level of creditworthiness to qualify for an unsecured line of credit.

What banks give out unsecured lines of credit?

Many major banks offer unsecured lines of credit, including Wells Fargo, Bank of America, U.S. Bank, and Citibank. Credit unions and online lenders also offer unsecured lines of credit. It’s always best to shop around to determine who can offer you the best rate and terms for your situation.

Photo credit: iStock/Erdark

SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOSMB-Q324-037

A due-on-sale clause — also known as an alienation clause — is wording commonly found in the fine print of a mortgage agreement. It allows lenders to enforce being repaid for the balance of a home loan when the property is either sold or, in some instances, transferred to another owner. That’s a simple explanation, but there is more to it so let’s dig a bit deeper.

What Is a Due-on-Sale Clause?

Understanding how home loans work is an important part of the home-buying process. Here’s what to know about a due-on-sale clause before you sell or purchase a home:

Definition and Purpose

A mortgage due-on-sale clause or alienation clause requires that the loan be paid in full when the home is sold. You may have heard about assumable mortgages becoming more popular as a way for buyers to sidestep higher interest rates by taking over a seller’s mortgage at a lower-than-typical rate. The due-on-sale clause prevents one buyer’s mortgage from being assumed by whoever purchases the house next.

Lenders began using due-on-sale clauses in the 1970s as interest rates spiked and buyers assumed the seller’s loan instead of applying for a new one with a higher rate. While homeowners won several court battles against this rule during the time, the U.S. Supreme Court ultimately ruled in favor of the banks. Congress formally legalized the due-on-sale clause for mortgages with the Garn-St. Germain Federal Depository Institutions Act in 1982.

Where It’s Found in Mortgage Documents

A due-on-sale clause should be located in your loan agreement. If you can’t find it in your paperwork, it’s worth calling your lender, especially if you plan to sell your house soon. Most, if not all, conventional loans are not assumable, meaning there should be a due-on-sale clause in place.

Some mortgages are assumable, and don’t have this type of clause in the loan agreement. Assumable loans include:

•   FHA loans backed by the Federal Housing Administration

•   VA loans backed by the U.S. Department of Veterans Affairs

•   U.S. Department of Agriculture loans

Remember, though, that even if a loan is assumable, the new borrower still needs to qualify for the loan. In many situations, however, they don’t have to go through the whole mortgage process. They simply get to assume the existing mortgage from the original owner. Also note that there are unique FHA flipping rules that you may need to be aware of if purchasing a home that has been owned by the seller for a brief time is a part of your plan.

Recommended: Choosing a Mortgage Term

How the Due-on-Sale Clause Works

Now that you understand what an alienation clause or due-on-sale clause is, find out how it works so you can avoid lenders invoking this portion of your loan agreement.

Triggering Events

Lenders are notified when ownership of a property securing a loan is transferred. If the seller doesn’t automatically pay off the loan balance at closing, the lender may choose to invoke the due-on-sale clause.

There are a few other situations that would cause a lender to invoke the due-on-sale clause. These include:

•  Transferring the property to a family member without a death or divorce

•  Transferring the property into an irrevocable trust

•  Transferring the property into a lease of more than three years

•  Changing ownership from a personal property to an LLC or vice-versa

•  Creating a junior lien that would lower the lender’s stake in a property

Lender Rights and Actions

In these cases, the lender could require the recipient of the property to transfer the title back to the original owner. The recipient usually has a set amount of time to do this, such as 30 days.

Another option for lenders, however, is to foreclose on the home if the original borrower is unable to provide the remaining mortgage balance. In these situations, refinancing the property or possibly modifying the original loan are also possibilities. (To see how much your monthly payment would likely be after a refinance, use a mortgage calculator.)

Impact on Property Transfers

The due-on-sale clause makes it more difficult to transfer properties to new owners. After the Supreme Court ruling, those recipients must meet certain criteria. Plus, even if they do meet the criteria, they must still qualify for the loan.

Exceptions to the Due-on-Sale Clause

There are exceptions that cause the due-on-sale clause to not take effect. Those exceptions are:

•  Divorce: If the original borrower loses the house in a divorce settlement, the due-on-sale clause should not go into effect.

•  Inheritance: Should the primary borrower die, then their children or surviving spouse can inherit the house without triggering the due-on-sale clause. With the average mortgage length being 30 years, it’s understandable that unique rules had to be put in place to account for buyers dying before their mortgage was fully paid.

•  Joint tenancy: If two or more people jointly own a property, then the death of one owner doesn’t trigger the due-on-sale clause. Instead, whatever portion of the property was owned by the deceased borrower is transferred to the other remaining borrowers.

•  Living trust: When a property is transferred to a living trust, there are no legal ramifications. A living trust is when a trustee is designated by a property owner to manage an estate.

Implications for Buyers and Sellers

If you’re the seller, the due-on-sale clause simply means that whatever money you make in the sale of your house must be adequate to satisfy your remaining loan balance. If it doesn’t, you have to be able to pay off your remaining mortgage obligations with other funds.

For the buyer, the implication of the due-on-sale clause is that the seller will have a minimum price that needs to be met in order for them to sell the home. The original lender must receive the amount it is due, or the house will not be free and clear for sale.

Fortunately, the desire to transfer an existing mortgage to a new borrower who is unrelated to the seller doesn’t happen very often.

Legal Aspects and Enforcement

It’s important to remember that there are situations where the due-on-sale clause cannot be invoked. As noted above, a title transfer that occurs because of a divorce or death usually forbids lenders from seeking immediate repayment. And even if lenders are within their rights, they still must provide ample notification before invoking the due-on-sale clause.

Recommended: Active Contingent in Real Estate: What You Need to Know

The Takeaway

The due-on-sale clause (or alienation clause) limits who can take over an existing mortgage from a homeowner, and it essentially establishes a minimum sales price that a buyer would have to meet in order for a seller to be able to agree to a contract. This is because lenders must always receive any remaining money owed on a mortgage when a home is sold.

Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.

FAQ

Can I transfer my property without triggering the due-on-sale clause?

It depends on the situation, but there are some situations where it can be done, depending on the original loan agreement. For example, it’s often possible to transfer a property during a divorce, and it’s also possible to transfer the property to an immediate family member after the death of the primary borrower.

What happens if I violate the due-on-sale clause?

If you violate the due-on-sale clause, the biggest thing that can happen is that your lender can demand immediate full repayment of your outstanding loan balance. If you are unable to pay, then you are at risk of foreclosure, which can damage your credit score for seven years.

Are there any mortgages without a due-on-sale clause?

It’s rare to find a conventional mortgage without a due-on-sale clause because it’s in the lender’s best interest. However FHA, VA, and USDA loans typically don’t have this clause.

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Both the U.S. prime rate and LIBOR are benchmark interest rates that play a role in what banks charge their customers for loans. However, there are some key differences between these two indexes.

The prime rate is set by each bank and is tied to the U.S. Federal Funds Rate. While the prime rate is variable, it may remain fixed for long periods of time. LIBOR (London Interbank Offered Rate), on the other hand, is an interest rate average based on what leading banks in London say they would charge for a short-term interbank loan. LIBOR changes daily and reacts to current market events.

Another key difference: Prime rate isn’t going anywhere, but LIBOR has been phased out and replaced by SOFR (Secured Overnight Financing Rate) in the U.S.

In the meantime, here’s what you need to know about LIBOR vs. prime rate, how these rates are set, and how they affect the cost of borrowing for consumers and small businesses.

What Is LIBOR?

LIBOR has long been a key benchmark for setting the interest rates charged on adjustable rate loans, mortgages, and corporate debt. One reason for its popularity is that LIBOR makes it easy to calculate rates for upcoming dates. You can get a LIBOR rate for an overnight short-term loan, or you can get a rate for 365 days from now.

However, due to numerous scandals and questions around its validity as a benchmark rate, the U.S. has largely shifted away from using LIBOR. Therefore, within the U.S. market, it’s no longer a case of LIBOR vs. prime rate, since there are very few scenarios where U.S. banks are allowed to use LIBOR. In the U.S., LIBOR is currently no longer used to issue new loans.

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How LIBOR Is Calculated

Every day, the Intercontinental Exchange (ICE) asks roughly 18 global banks at what rate they would charge for a loan in a specific currency and a specific maturity. Those currencies include:

•  Euro

•  Japanese yen

•  Pound sterling

•  Swiss franc

•  U.S. Dollar

For each currency, the top 25% and the bottom 25% are removed. The remaining rates are averaged. This is done for each maturity, which includes:

•  Overnight

•  One week

•  One month

•  Two months

•  Three months

•  Six months

•  One year

In total, there are 35 LIBOR rates published everyday. This is one of the biggest differences between prime rate vs. LIBOR. LIBOR is calculated daily and for multiple currencies, while prime rate is not.

Recommended: What Is Funds From Operation?

What LIBOR Is Used For

Lenders, including banks and other financial institutions, have used LIBOR as the benchmark reference for determining interest rates for various debt instruments, including mortgages, corporate loans, government bonds, credit cards, and student loans.

Apart from debt instruments, LIBOR has also been used for other financial products like derivatives, including interest rate swaps or currency swaps.

What Is Prime Rate?

Prime rate is the rate banks give to their best, most creditworthy corporate customers. However, it’s not the rate most businesses will pay. The rate a bank would quote you for most types of small business loans will simply be based on the prime rate. The prime rate is also used to set rates for credit cards, mortgages, and personal loans.

When comparing business loan rates, you might come across lenders that express the terms of a loan as “prime plus” a certain percentage. The percentage that gets added to prime will depend on the borrower’s credit rating and other factors.

How Prime Rate Is Calculated

The prime rate is tied to the Effective Federal Funds Rate, which is the target for the interest rate banks charge each other for short-term loans. The federal funds rate is established by the Federal Reserve and is based on the economy’s current conditions. Banks generally add 3% to whatever the federal funds rate is. Therefore, if the federal funds rate is 2%, then the prime rate would likely be 5%.

However, there isn’t any single prime rate. Each bank sets its own prime rate that it charges its best customers. But because banks want to remain competitive with one another, many will actually adopt the same or very similar prime rate.

You may have also heard of the WSJ Prime Rate. In a similar fashion to LIBOR, each day the Wall Street Journal asks the largest banks within the U.S. what rate they would charge for a short-term loan to their most qualified customers. When 70% of the banks change, WSJ Prime Rate changes, too.

Recommended: Average Business Loan Interest Rates for 2024

What Prime Rate Is Used For

Prime rate is used as a benchmark when establishing rates for many loan products. These loan products may include:

•  Credit cards

•  Small business loans

•  Auto loans

•  Mortgages

•  Personal loans

•  Student loans

The prime rate is the starting point for establishing what rate a customer will receive when taking out a loan. However, many things affect what rate a borrower will get. Credit scores, income, debt-to-income ratio, collateral, fixed interest vs. variable interest, and maturity also play key roles in determining how much a person or business will ultimately pay for a loan.

Recommended: What Is the Minimum Credit Score for a Business Loan?

Differences and Similarities Between LIBOR and Prime Rate

There are some similarities between prime rate and LIBOR, as well as some key differences.

Similarities

•  Both rates are used as reference points for lending transactions.

•  Both are based on surveys given to large banks asking them at what rate they would lend.

•  Both tend to move in the same direction as the federal funds rate.

Differences

•  Prime rate is a reactive rate. It only moves after the federal funds rate has changed.

•  LIBOR is an anticipatory rate. It moves in anticipation of economic conditions.

•  LIBOR is used by five different currencies, with seven different maturities.

•  In the U.S., commercial banks may each have their own “prime rate” that they issue to their most qualified and best borrowers.

•  LIBOR is published by the ICE (Intercontinental Exchange).

The most quoted prime rate is published by the Wall Street Journal (WSJ).

Pros and Cons of LIBOR

Pros and Cons of Prime Rate

Recommended: Business Cash Management, Explained

Secured Overnight Financing Rate (SOFR)

The Secured Overnight Financing Rate (SOFR) was introduced in 2017 to replace LIBOR as a key benchmark for loans, derivatives, and other financial products. It reflects the cost of borrowing cash overnight and is collateralized by U.S. Treasury securities. Unlike LIBOR, which relied on estimates, SOFR is seen as more accurate and less susceptible to manipulation, promoting stability in the financial system.

The transition from LIBOR to SOFR was effective as of July 1, 2023 in certain financial contracts.

The Takeaway

Both prime rate and LIBOR act as benchmark interest rates. However, LIBOR can be used to calculate future loans because it’s the rate that banks expect they’ll lend at in the coming weeks and months. Prime rate, on the other hand, only represents the going rate.

Prime vs. LIBOR was once a talking point among lenders, but since the end of 2021, LIBOR has been steadily phasing out. While still used in some situations, the U.S. has switched to SOFR and the U.S. dollar LIBOR setting has permanently ceased.

As a borrower, a benchmark rate, like prime or LIBOR, is only one of many factors that go into determining the interest rate you’ll pay for a loan. If you’re applying for a small business loan, lenders will also look at your credit scores, time in business, annual revenue, and collateral when determining your rate.

If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.

FAQ

How are prime rate and interest rate different?

A bank’s prime rate is the rate it charges its most qualified corporate customers, who are highly unlikely to ever default on a loan. An interest rate is the rate a bank will charge other businesses and consumers for loans.

What does LIBOR stand for?

LIBOR stands for the London Interbank Offered Rate.

Why do U.S. banks use LIBOR?

U.S. banks used LIBOR (London Interbank Offered Rate) as a benchmark because of its global popularity and adaptability in setting the rates for future loans. However, due to its role in numerous scandals, LIBOR has since been replaced with SOFR (Secured Overnight Financing Rate) in the U.S.

Photo credit: iStock/cagkansayin

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