If you run a small business, you’re likely seeing a flood of offers for easy-to-get loans–through direct mail, popup adds, even TV ads promising fast money to pay your bills or buy new equipment
You’re not alone. Alternative small business lending has exploded in the last few years as a new industry emerged, referred to as “fintech” (for financial technology).
“It’s been the wild west,” said Karen Gordon Mills, co-author of a new Harvard Business School study with co-author Brayden McCarthy. Released November 30, “Small Business Lending: Innovation and Technology and the Implications for Regulation” looks at the promise and challenges of this new sector in relation to small companies.
Typically, to get a loan, a small business owner needs to provide a bank with tax returns, personal and business financial statements, and a pile of other documents and data. “You have to wait weeks or months,” said Mills.
Moreover, there’s been a persistent “credit gap”—a dramatic lack of funds available for small businesses needing smaller amounts of money, less than $250,000.
Now, dozens of companies—OnDeck, Kabbage, FundBox, BlueVine, and the scandal-rocked Lending Club—are eager to lend money to small businesses. In addition, a number of platforms—Fundera, NerdWallet, Quickbooks Financing, Biz2Credit, and Lendio—have emerged to connect small businesses with these new lenders.
Fintech lenders use more current, more 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,” said Mills. “It’s transformative.” Because it’s easier to reach potential borrowers and to assess risk, they can profitably offer loans “even as low as $7,000 to $10,000.” Such loans have been virtually impossible to get from a bank.
But there’s a hitch. “No federal regulator has authority over small business borrowing the way they do over consumer borrowing,” said Mills. “The Truth in Lending Act does not apply to small business borrowers, so you don’t have transparency. Small businesses might not know what they’re paying.”
As a result, these new lenders can—and often do—charge sky-high interest rates and pile on 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 to small business market,” said co-author McCarthy, Vice President of Strategy for Fundera, an online lending platform. “It’s been ignored for a long time, but we want to make sure that disclosures are robust enough so borrowers know what they’re getting in to.”
Some problems identified in the Harvard Business School report:
- High costs: Lenders commonly 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 loan.
- Hidden prepayment charges: Unlike traditional loans, many alternative lenders require payment of the full interest even when loans are repaid early.
- Misaligned broker incentives: Small business loan brokers often recommend the most expensive loans because they earn the highest fees on those.
- Stacking: Multiple lenders provide loans to the same borrower, resulting in additional and hidden fees.
It’s not enough to say “let the buyer beware.” Understanding how much a loan truly costs is difficult even for sophisticated borrowers. “A Harvard MBA class was asked to decipher the APR on loans of less than one year, considering originating fees, closing fees, other fees. Forty percent were ex-investment bankers or had come from the world of finance,” said McCarthy. “More than half got it wrong.”
“We’re not calling for new regulation,” said Mills, “but a streamlining of existing regulation. 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 this credit gap.”
What the Harvard Business School Report recommends:
- Mandatory disclosure of APRs, fees, default rates, and borrower satisfaction
- A national regulation option—rather than state-by-state
- Increased borrower protections for small business owners
- Rules/guidance on partnerships between banks and new lenders
- Brokers/platforms to have a “fiduciary” duty toward borrowers, meaning they must act in the borrowers’ best interest and disclose conflicts of interest
Copyright, Rhonda Abrams, 2016
This article originally ran in USA Today on November 30, 2016
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