When banks turn them down for loans, small businesses are increasingly turning to online “alternative” lenders. The loans they provide can be a lifeline, but higher interest rates mean you should proceed with caution
Despite a loosening of the purse strings among banks that lend to small businesses, many entrepreneurs still find it difficult to get the loans they need. Increasingly they are turning to online alternative lenders. But using these high-interest products requires extra care or you could wind up in worse shape than when you started.
In a 10-state survey, the Federal Reserve Banks of New York, Atlanta, Cleveland and Philadelphia found that nearly one in five small businesses used online lenders in the first half of 2014. “This new emergence of alternative lenders is not going away,” says attorney Andrew Sherman, who advises businesses of all sizes as a partner at Jones Day in Washington, D.C. “They are going to be a bigger and bigger part of small and entrepreneurial companies’ access to financing.”
What is driving the trend? While small business lending has increased since the Great Recession, many banks prefer to make loans over $1 million, rather than less profitable smaller loans. But small businesses often need those smaller loans. The Fed survey found that in a 10-state area, 62 percent of small-business borrowers sought loans of less than $100,000.
The tiniest firms, with $250,000 or less in annual revenue, fared worst in getting approved. Fifty-two percent did not receive a single dollar for which they applied. And half of businesses with revenue from $250,000 to $1 million were turned down for all the credit they sought. The most common places to apply were large regional banks, followed by large national banks.
That has left a gap in the marketplace, and online lenders using fast-evolving digital technologies are increasingly trying to fill it. Eighteen percent of applicants turned to an online lender in the first half of 2014, according to the survey, with 22 percent of startups less than five years in business doing so.
The rates on alternative loans are all over the map. Given that the lenders will often provide loans to firms that would not qualify for a bank loan because they are startups or the owners have less-than-perfect credit, the rates can be substantially higher than for a Small Business Administration-backed 7(a) bank loan. As of May 2015, for SBA loans with maturities of less than seven years, interest is capped at about 5.5 percent — equal to the prime rate (currently 3.25 percent) or one of two other rates the government uses, plus no more than 2.25 percent.
In contrast, World Business Lenders, a lender in New York City, charges rates of up to 125 percent, according to Business Week. Another small-business lender, OnDeck, said in a December 2014 filing with the Securities and Exchange Commission, that its annual percentage rate was 53.2 percent in the third quarter of 2014. OnDeck’s loans are originated in Virginia, which does not regulate interest rates on commercial loans of $5,000 or more, and some are sold to institutional investors through a marketplace the firm has created, the document says.
In a written statement sent to CreditCards.com, Andrea Gellert, OnDeck’s senior vice president of marketing, said, “OnDeck’s rates go as low as 19.99 percent APR for our Term 24 loan. We also offer a line of credit with APRs ranging from 29.99 percent to 49.00 percent, where repayment is amortized over six months. New customers can receive a line of credit of up to $20,000. The weighted average APR of all OnDeck loans originated in Q4 2014 was 51.2 percent, a decline of over 10 percentage points from Q4 of the prior year.”
Lending Club, which does both consumer and small-business lending, depends on WebBank in Utah to originate loans. According to the firm’s S-1 statement in August 2014, there’s no firm cap on loans in Utah. The state generally lets the parties to a loan agree on what the interest rate will be.
In a phone interview, Tom Green, vice president of new business initiatives at Lending Club, said that 5.9 percent is the best rate available for small-business loans but rates range up to 25.9 percent. When fees are taken into account, a $100,000 term loan paid over 12 months at 25.9 percent interest would cost $17,568 and have an effective APR of 31.9 percent, according to a document he furnished. In contrast, with an early payoff after three months, it would cost $8,983 and have an effective APR of 39.7 percent. (Flat fees for origination make the effective APR higher but the overall costs lower if you pay off the loan early.)
Lending Club competitor Prosper also relies on WebBank for loan originations, and its maximum interest rate is 36 percent.
Ronnie J. Phillips, a Professor Emeritus of economics at Colorado State University, believes it’s a “tossup” as to which alternative lenders are best to use, if this is your only option. “They are all fairly high interest rates,” Phillips says. “You are really paying for convenience and quickness.”
Deciding whether to use a subprime lender
Before you borrow, experts say it is essential to justify the risks you are taking by figuring out whether any profits you make by putting the money to work for you will exceed the cost of financing.
“They need to evaluate it very carefully,” says Ramit Arora, president of Biz2Credit, a New York City-based matchmaker between borrowers and lenders. Biz2Credit has introduced its own peer-to-peer lending product with rates ranging from 11 percent to 18 percent.
Here are some tips to guide your decision if you are thinking about using alternative financing.
1. Consider other options first. The Fed’s survey found that both large and small community banks and online lenders have the highest loan approval rates of all financing sources. Given that community banks typically offer lower interest rates than alternative lenders, meeting with a community banker is a good first step in your money hunt. You may find you qualify for a conventional bank loan and don’t need pricier alternative products.
If you are not considered loan-ready, a community bank may send you to a microlender so you can build more of a credit history and then come back in the future.
“It’s a good way for a new business to start out, get some initial funding and build a credit track record,” says Tom Woolway, senior vice president of Torrey Pines Bank in San Diego and manager of the Carmel Valley/North Coastal region. His bank works closely with the nonprofit microlender Accion San Diego, which makes loans up to $35,000 available to small businesses referred by the bank.
Accion USA, the nationwide parent organization, says reputable microlenders charge interest rates in the range of 10 to 16 percent. Bank loans tend to range from 5 percent to 7 percent, Woolway says.
Some small-business owners contact microlenders directly. Accion USA says it makes loans from $2,500 to $25,000 to existing businesses at interest rates starting at 10.99 percent. It lends up to $50,000 to returning customers.
And don’t overlook credit card financing if you need a small amount you are confident you can pay back quickly. The current average business credit card rate is 12.85 percent.
2. Be realistic. If you do turn to alternative financing companies, understand that, while they will work with businesses that banks turn away, they don’t want to take crazy risks. “If you are a business owner and your revenue is half a million dollars, that doesn’t mean you’ll be able to get half a million dollars,” says John Lynch, marketing director at ExpressBusinessLoans.com, an alternative financing platform based in Amityville, New York.
How much of a cash infusion can you expect from an alternative lender? “I would say with any financing product, they’re looking at 10 percent to 20 percent of your gross revenue,” says Lynch. “There are exceptions, and that is a ballpark figure.” The variables include your cash flow, your business’s credit history, the type of business you run, your industry and the geographic area, he says.
At Prosper, the average loan is $14,000, according to president Ron Suber. “Peer-to-peer platforms have been doing a very good job of not giving out too much credit to people that have not had the ability to pay back,” Suber said in a phone interview. “Defaults have been quite low.”
The estimated loss rate on Prosper loans ranges from 1.5 percent for those with the best credit to 15.9 percent for those with the poorest credit history.
3. Expect scrutiny. Alternative financing deals often require less paperwork than a bank loan, but gathering it still takes time. Ask your financing source what documents you need to submit early in the application process, so you can keep things moving quickly. ExpressBusinessLoans.com, for instance, will look at the last three months of a business’s bank statements, and, for a client seeking $75,000 or more, the last year’s tax return and both a profit and loss statement and balance sheet prepared by an accountant. “That gives us an idea of how a business is performing,” Lynch says.
Getting your finances in shape before you apply can pay off with a better interest rate. A business that is in the red will be less attractive to both alternative financing companies and banks — and it will often pay higher interest. “At some point, a business owner has to take that into account. Is he looking to build credit with the business or looking to take profits right away?” says Lynch.
4. Know what you are paying. It can be particularly difficult to figure out exactly what you’re paying for merchant cash advances, currently a heavily-promoted product. The lending site Fundera publishes a calculator you can use to convert the daily interest rate for a merchant cash advice to an annual percentage rate. When in doubt, ask your accountant to help you calculate the actual interest rate before you sign for a loan.
Also pay attention to what you will pay if you are late. Subprime lenders may penalize you with interest rates that are two to three times higher than your initial rate, says Nick Bourke, who leads the Pew Charitable Trusts’ research on small-dollar loans. “There’s nothing in the law that prevents that from happening on a small-business loan or credit card,” he says.
And some lenders may encourage you to refinance by letting you skip a payment, he says. “Whenever there is refinancing, there are a lot of new fees,” Bourke says.
5. Borrow for the right reasons. The smartest alternative financing deals will help you make money in the end, not just keep your lights on for another day. “The interest rates are high relative to lending rates, but since interest rates are so historically low, the actual cost of capital may still be reasonable depending on the project and allocation of capital,” says Sherman, the attorney.
Chris Carey is CEO of Modern Automotive Performance, a provider of performance auto and truck parts in Cottage Grove, Minnesota, with $11 million in annual revenue and 37 employees. His firm, which is almost profitable, uses a loan product from OnDeck to buy inventory at lower prices in preparation for the spring busy season. He pays 18 percent interest, but having cash on hand lets him approach suppliers to negotiate volume discounts, which he weighs against his financing costs..
“Generally, we’ll plan this ahead of time and say, `If we buy $20,000 worth at one time, how much of an extra percentage off can we get?” says Carey.
Carey tried getting financing for these orders through his bank first but found they had little interest in making small loans. Instead, he has taken out a series of six or seven OnDeck loans ranging from $100,000 to $200,000. OnDeck deducts a fixed percentage of what he owes from his bank account each day by ACH transfer. He took out his most recent loan, for $200,000, in January. “I’ve never experienced a missed payment or asked them to defer one,” he says.
But Carey uses cheaper funding when he can. A couple of years ago, he took out an SBA-backed bank loan in the $600,000 to $650,000 range at about 5.5 percent interest to finance inventory and equipment. He also took out a real estate loan for $1.2 million through the SBA’s 504 real estate and equipment program, with interest “in the mid to low fours,” he says.
6. Think “short term.” Like credit cards, alternative financing products are intended for short-term use. “These opportunities are like a bridge loan,” says Nathan Sklar, CEO of Comprehensive Staffing in New York City, who recently borrowed through Biz2Credit’s peer-to-peer lending program. “I don’t think it’s a long-term fix.”
Sklar’s firm, which has around 500 full-time and temporary employees, generates revenue in the $20 million to $30 million range, he says. He has taken a number of small loans through Biz2Credit in the past couple of years to meet short-term cash flow needs. But these loans — in amounts of $20,000 to $120,000 — have been supplements to longer-term, lower-cost financing. He also has “a couple of million” in lower-cost bank loans, he says.
7. Avoid the Band-Aid approach. Many borrowers, alas, approach alternative lenders when they are desperate. For instance, they may take out an emergency loan to pay another existing one. “That’s like putting out a fire with gasoline,” says Sherman.
If you’re in a situation like this more than once, it’s time to get advice from your accountant on cash-flow management — today. You may be funding a firm that isn’t viable or putting your company at risk by overlooking more sustainable methods of keeping cash on hand, like invoicing promptly. “You’ve created your own internal pyramid scheme,” says Sherman. “You’re robbing Peter to pay Paul.”