If you run a small business, you’ll likely see a flood of easy-to-get loan offers — through direct mail, pop-up ads, even TV ads — promising quick cash to pay your bills or buy new equipment. But this new world of quick money can come with some costly catches.
“It was the Wild West,” said Karen Gordon Mills, co-author of a just-released Harvard Business School study exploring the promises and challenges of alternative small business lending. The sector has exploded in recent years with the emergence of a new industry, called “fintech” (for financial technology).
Typically, to get a loan, a small business owner must provide a bank with tax returns, personal and business financial statements, and a slew of other documents and data. “You have to wait weeks or months,” said Mills, who co-authored the report “Small Business Lending: Innovation and Technology and the Implications for Regulation” with Brayden McCarthy.
Additionally, there has been a persistent “credit gap” – a dramatic lack of funds available to small businesses needing smaller sums of money, less than $250,000.
Today, dozens of companies — On the bridge, Cabbage, FundBox, BlueVine, Prosper and the Lending Club scandal – are eager to lend money to small businesses. Additionally, a number of platforms — Fundera, NerdWallet, Quickbooks financing, Biz2Credit and Lendio — have emerged to connect small businesses to these new lenders.
Fintech lenders use more current and digitized information than traditional bankers. For example, with permission, they can directly access a company’s QuickBooks accounts. “You get your answer in minutes or hours, and you get your money in hours or days,” Mills said. “It’s transformative.” Because it’s easier to reach potential borrowers and assess risk, they can offer profitable loans “even as low as $7,000 to $10,000”. Such loans have been virtually impossible to obtain from a bank.
But there is a catch. “No federal regulator has authority over small business borrowing like they do consumer borrowing,” Mills said. “The truth in the lending law doesn’t apply to small business borrowers, so you don’t have transparency. Small businesses might not know what they are paying.
As a result, these new lenders can – and often do – charge exorbitant interest rates and rack up fees, often hidden from the borrower. A short-term loan can turn into a long-term nightmare.
“There’s so much promise in the rise of lending in the small business market,” said co-author McCarthy, vice president of strategy at Fundera, an online lending platform. “It’s been ignored for a long time, but we want to make sure the disclosures are strong enough for borrowers to know what they’re getting into.”
Some issues identified in the Harvard Business School report:
- High costs. Lenders typically charge APRs (Annual Percentage Rates) above 50% and can easily reach over 300%.
- Double dipping. Repeat borrowers incur additional fees each time they renew their loans.
- Hidden prepayment charges. Unlike traditional loans, many alternative lenders require full interest payment even when loans are prepaid.
- Misaligned broker incentives. Small business loan brokers often recommend the most expensive loans because they charge the highest fees on them.
- Stacking. Several lenders give loans to the same borrower, which leads to additional and hidden costs.
It is not enough to say “buyer beware”. Understanding how much a loan really costs is difficult, even for sophisticated borrowers. “A Harvard MBA class was asked to decipher the APR on loans less than a year old, taking into account origination fees, closing costs and other fees. Forty percent were former investment bankers or came from the world of finance,” McCarthy said. “More than half were wrong.”
“We’re not asking for new regulations,” Mills said, “but streamlining existing regulations. With the new president, we know there will be new legislation. …Let’s make sure small business borrowers are protected. But let’s also make sure lenders have a chance to close that credit gap.
What the Harvard Business School report recommends:
- Mandatory disclosure of APRs, fees, default rates and borrower satisfaction
- A national regulatory option — rather than state-by-state
- Enhanced borrower protection for small business owners
- Rules/guidance on partnerships between banks and new lenders
- Brokers/platforms must have a “fiduciary” duty to borrowers, which means they must act in the best interests of borrowers and disclose conflicts of interest
Rhonda Abrams is the author of 19 books including “Successful Business Plan: Secrets & Strategies” now in its sixth edition. Connect with Rhonda facebook.com/RhondaAbramsSmallBusiness and twitter: @RhondaAbrams. Sign up for Rhonda’s free business advice newsletter at www.PlanningShop.com