Avoid Alternative Business Loan Traps
Small business owners who apply for loans with traditional lenders often face rejection. Large banks reject 44% of all small business loan applications, so if you find yourself in this situation you are hardly alone. Given that your need for capital, either to maintain day-to-day operations or expand, is unlikely to have gone away, what is next?
For many small business owners the answer to this question is to turn to an alternative lender. Their approval rates are much higher, at 75%, and they are easier to work with. But there are downsides and risks to working with them, and smart business owners should educate themselves about the industry, its products, and how to avoid falling into common alternative lending traps.
The Alternative Lending Industry
The alternative lending industry sprang into existence to fill a gap left by traditional lenders. After the market crash in 2008 banks tightened their lending standards. Approval rates for small business loans plummeted but business owners still needed access to capital.
Alternative lending companies came into being to lend to those who could not obtain capital from banks. Their market is now estimated to represent $62.3 million of small business lending, with steady growth in the numbers of loans extended every year.
In addition to an inability to qualify, business owners needed access to smaller amounts of capital. Many banks prefer to only lend large sums of money, as often the costs to underwrite a small loan is the same as a large loan but they make more money on a large loan. The average loan size for large banks was $493,000 versus a loan size of $80,000 for alternative lenders.
Because alternative lending products are structured as contracts for a purchase and sale, rather than interest-based term loans like those at a bank, the industry is not regulated. The industry does not submit reports on its loans to the Federal Reserve, and does not have to comply with loan quality standards. This gives them great freedom in lending, which unfortunately can lead to abuses.
There are three common products that alternative lenders offer, all of which can lend themselves to abuse.
Short-Term Alternative Lending Loans
A short term business loan is best for seeing you over a quick hiccup in cash flow. Most banks avoid short term loans because they do not have enough time to make a good profit on them. Alternative lenders solve this problem by charging higher interest rates.
Loan terms are from six to twenty-four months, and interest rates range from 9% to 45%. To qualify, you must have minimum revenues of $10,000 a month. It is repaid by automatic withdrawals from your bank account.
Merchant Cash Advances
Merchant cash advances or MCA’s are another popular form of alternative lending. When you apply for a MCA the lender analyzes your cash flow. They will typically ask for several months of bank or credit card statements off which they calculate an average.
The amount they lend to you is based off that average and expected future cash flows. You are pledging your future cash flows to them at a discount, essentially selling future sales.
One of the key differences between an MCA and a short term business loan is that the lender is repaid by taking a percentage of your credit card transactions. Instead of deducting repayments from your bank account they deduct a percent of each swipe going forward.
The percent deducted includes both their loan principal and interest in the form of the discount they applied to the loan’s principal.
Bad Credit Business Loans
Bad credit business loans are given to those who have poor credit or do not qualify for a loan at a bank. The term “bad credit” simply refers to a loan which does not meet a traditional lenders’ requirements. This could be for many reasons which are unrelated to a credit score, from the time a business has been in operation to their industry.
A bad credit business loan’s term can be from two to eighteen months, and rates range from 12% to 45%. A business only needs $8,000 in monthly revenues to qualify and the owner can borrow as long as their credit score is above 500.
Common Alternative Lending Traps
Unscrupulous lenders might lend under terms and rates that could cripple your business. You want to avoid these common traps when borrowing from an alternative lender.
The Outrageous Premium Trap
If you borrow from an alternative lender who will pay a higher interest rate than at a traditional bank. This is a given. Alternative lenders charge rates ranging from 9% to 45% in order to cover the higher amount of risk they are taking when lending to you.
But if the premiums they are charging on your loan make it hard for you to meet the repayment schedule and maintain your business’ daily operations, you have fallen into a trap.
The outrageous premiums trap is meant to keep you in a cycle of always needing to borrow to maintain adequate cash flow. As soon as one loan is paid off you have to apply for another, and you remain indebted to the lender for years. Often, you can end up paying far more in interest than you originally borrowed.
The Lending Irresponsibly Trap
Closely associated with the trap of outrageous premiums is the trap of irresponsible lending. Lenders typically perform due diligence when approving a loan. They will calculate a debt service ratio or debt to income ratio to measure your repayment ability, and will not lend in amounts that you could struggle to repay.
Some lenders, however, will lend irresponsibly. They will only consider their own profit margins and own needs, and not your cash flow. If they have made enough in interest and you have assets they could seize they might not even care about repayment.
If you fall into this trap and take out a loan for too much money it could end your business.
The Interest-Only Payment Trap
Payday lenders are notorious for trapping borrowers in the interest-only payment trap. The borrower thinks that their bi-weekly payment is going towards both principal and interest when, in reality, it is only paying interest. This means that at the end of the loan’s term they have made no progress paying it down and have to roll the loan into another payday loan.
Making interest-only payments on a loan are rarely a good idea. Unless you know with relative certainty that you can repay the balloon payment of principal when it comes due, it is best to avoid them. It can be both disheartening and frustrating to not make progress on paying off a loan but still be making monthly payments.
Avoiding Alternative Lending Traps
When deciding to apply for a loan with an alternate lender take some time to research the market.
Look into the Alternative Lender
First and foremost, investigate the company’s legitimacy.
Does the company have a robust social media presence and do they post often? This is a good sign that they are actively engaged with their customers and the market. Read any reviews posted on their social media channels, and pay attention to how they respond to online complaints.
Also ask how long they have been in business. If they have been in a business for a while, such as Shield Funding’s ten years, it indicates that they know how to lend responsibly and to satisfy customer needs.
Look into whether or not the lender has registered with the Better Business Bureau. If they have there will be a log on any complaints and their resolution online, as well as an overall company rating.
Analyze your Numbers
Want to know how to avoid the outrageous premiums trap? Perform your own analysis.
Before applying for a loan put together a detailed budget and business plan for how you intend to use its funds. You will want to know that the amount of money your investment of capital generates is higher than the cost of that capital. If you pay 12% to borrow, your return on investment should be higher than 12%.
You can calculate your return on investment by dividing the investment’s benefit, perhaps increased revenues, by its cost.
Analyze your Cash Flow
To avoid falling into the irresponsible lending trap, analyze your cash flow. When examining your monthly budget, will you be able to make the loan’s payments with ease? The good news is that many alternative lenders offer extremely flexible repayment plans, so instead of making one large, monthly repayment you could pay back a small amount daily, weekly, or bi-weekly.
Calculate your free cash flow, which is the amount left over after you have paid for operating expenses and capital expenditures, to see if it covers the amount of your loan payment.
Analyze your Business Loan
Reputable lenders will take the time to answer all your questions and clearly lay out your loan’s terms. When you receive the approval letter, read through its terms carefully.
Make sure that your payments will go towards both principal and interest so you can avoid the interest-only payment trap. Look for any clauses that reference escalating interest. Some merchant cash advance lenders will raise your interest rate throughout the life of the advance if it takes too long for you to pay it off, and you want to avoid this.
Lastly, check for any prepayment penalties. If a project earns out faster than expected, or you receive an influx of cash, you want to be able to prepay your loan without penalty. But some alternative lenders do not want to forego the interest they had planned on earning. So they put prepayment penalties in your contract so that you have to pay them that interest, regardless.
The alternative lending industry exists to fulfill a need, but you must still borrow responsibly. Learning to analyze the financials of different business opportunities, including borrowing, is an important skill for any small business owner to develop. With some work on your end, and by applying with a reputable alternative lender, you can avoid all the common traps of alternative business loans.