In recent online focus groups, Federal Reserve researchers presented 44 small-business owners with basic information about a loan and asked them to estimate the interest rate. The business owners’ responses were telling. The Fed study discovers small-business owners are confused about the terms being offered by online lenders. On an annual basis the loans can be quite pricey and an industry leader, OnDeck, has average APRs of 46.5%, according to the company’s most recent earnings report.
The online lenders’ rates and fees can be next to impossible to compare which can be disastrous to a small business owner. On top of payday type interest rates, many companies that get loans from online lenders are not happy. Online lenders approved 71% of the applicants for at least some credit but just 15% of the businesses that got approved reported being satisfied. The two most common reasons that successful applicants cited for their dissatisfaction with online lenders were high interest rates and unfavorable repayment terms, a catchall category that could include prepayment penalties.
The issue at hand is transparency – what is the true cost to borrow from an online lender? Take a hypothetical loan, which was meant to mimic some of the products offered to small businesses online, is for $40,000. The borrower owes $52,000. The lender gets repaid by taking 10% of the borrower’s daily debit card and credit card sales. The loan is paid off in one year. So what is the interest rate? 10%? 23%? 30%? No, the effective interest rate is around 60%!
Online lenders have a place in the market and have filled a niche. Small businesses looking for a loan under $100,000 which are deemed too risky for traditional lenders need access to working capital and online lenders are happy to provide it. While the industry holds promise for expanding access to credit, it also raises potential risks for small-business borrowers as these products can be considerably more expensive than traditional credit.
Small businesses also have the option of borrowing from traditional lenders, such as factors. Factors have a self-regulating body and offer the transparency small business owners are looking for. Also, factors will continue to work with a business as it grows and contracts. Most online lenders are offering a short term loan which leaves a business unable to borrow more money when they need it most. Most significant to small business owners should be rate and structure. Factors on average charge 12-36%APR and offer flexible loan terms.
Small businesses have a choice when it comes to borrowing money but should choose wisely. One bad borrowing decision can deliver a fatal blow.