What are the Differences Between Private and Traditional Business Loans

business loan differencesAcquiring additional working capital is almost a necessity for any business. The small business lending process has changed substantially over the last few years and can vary greatly from lender to lender. Determining which option to pursue can be quite confusing. The most common types of funding today are traditional business loans offered from banks and business loans offered by private lenders. The two options are completely different and small business owners looking for additional capital are often left with a variety of questions when trying to determine the right loan for their business. This in-depth analysis highlights the lending process for both banks and private lenders in an effort to help business owners understand the funding process.

Where Does the Money to Lend Come From?

Most of the money that banks use to loan to businesses comes from the deposits made by banking customers, debt issuance, shareholder equity, and other forms of wholesale borrowing. The costs for acquiring this money are very low for banks. They offer such a small percentage as interest on deposits for banking customers which is generally their largest source of funds, but even when banks borrow money through their wholesale resources they borrow or trade balances based on the fed funds rate, which has been at 0.25 for some time now.

Private finance companies get their money from investors that pool together funds in order to generate returns on the capital. The investors that provide this money are interested in making returns significantly larger than what a bank would offer otherwise they would simply leave it in a bank where the returns are guaranteed. The need to incentivize investments into this pool of funds translates to higher money costs for private lenders. Providing insight into where the money comes from for the different lenders helps set customer expectations for borrowing costs.

Collateral Requirements

Almost any bank you go to will require collateral when applying for a business loan. A general guideline for collateral requirements is providing a blanket lien on your assets and the amount you can borrow will be substantially less than the value of those pledged assets. You will also be required to personally guarantee the loan.

The collateral requirements in the private sector are very different. Private lenders do not require collateral for their business loans and there are no personal guarantees required. All of the risk is transferred to the lender which is another major reason for the premiums associated with this type of borrowing.

Terms for Borrowing

Considering that banks have a low money cost and have very little risk on any given loan they typically offer more time on the life of the loan. A good example of the terms for standard business loans from a bank is 3 years but that term can vary from bank to bank and it depends on the type of loan.

Private lenders on the other hand have a lot of risk associated with lending so this impacts the amount of time offered for any funding agreement. Each lender can extend the life of the loan for any amount of time they choose but the general guidelines are 6 to 24 months with higher costs associated with longer terms.

Approval Factors

When a bank offers a standard business loan to a borrower it bases the approval on the 5-Cs to determine the quality of the borrower. This approach to lending is required for banks and their lending practices are monitored periodically by a safety and soundness examiner from a regulatory body. The 1st C focuses on the borrower’s ability to repay the loan and looks at debt to income and the source for payments. The 2nd C considers the type and amount of collateral provided. The 3rd C looks at the business owner’s current situation as well as the financial condition of the business and its future earning potential. The 4th C takes into account a borrower’s assets and liabilities. The 5th C considers the character of the borrower which is determined by the credit history of the borrower and the underlying business. The process of substantiating all of this data can last for several months and requires an enormous amount of paperwork and subsequent verification.

The approval process for private business loans is much more flexible in comparison to traditional loans. Private lenders base their approvals on the cash flow of a business. The main requirement is that the business owned by the applicant has consistent gross revenues. The average monthly revenues help lenders determine how much a business can borrow and later pay back. There is no collateral required and although private lenders look at credit history to understand the borrower, the credit score plays a very small role in determining an approval. As a result of the minimal paperwork and verification required the complete application and approval process can be much faster than acquiring a loan from a bank.

Cost of Borrowing

If you are a small business owner looking for a business loan you are likely to receive some of the best rates possible from a bank. There are several reasons why a borrower can receive such good rates. The bank’s money costs are low, they are likely to offer a variety of other financial services to a borrower so they can make significant profits over the life of a business relationship, and they require collateral and great credit which effectively lowers the risk involved with the loan.

Banks are typically free to set the interest rate they will charge for loans, but the competition from other banking institutions helps to keep the cost of borrowing from banks low. Although the potential interest rate a borrower may receive depends on various factors such as your relationship with the bank, amount borrowed, type and amount of collateral, credit history, and the prime lending rate, the general range today for borrowing from banks is around 6 to 8 percent. This does not include the additional fees that banks charge such as application and administration fees, closing costs, and other fees required to complete an application.

Private lenders offer business loans at higher rates than traditional financing. The main reason why private loans come at higher rates is because establishing a funding account that has enough money to lend to businesses requires financial incentives for the investors that put up the funds for the account. Also, there are significantly higher levels of risk involved because private lenders do not demand great credit, and borrowers are not required to put up collateral. Although private lenders are also free to set the rate this industry is witnessing a tremendous amount of growth so competition is helping to bring the cost down as well.

Private lenders do not charge interest rates but charge a fee for providing the funding. The loan is structured as a purchase and sales of future revenue, so there are no interest rates or accruing debt. The total amount borrowed plus the fee makes up the total cost of the loan. The fee range for this type of borrowing is much wider because there is such a broad spectrum of risk from client to client. For instance, a low credit score in a high risk industry will pay more on the loan then an individual with good credit in a stable industry whereas banks only lend to a prime borrower. The averages for fees on a percentage scale are generally between 10 and 35 percent. Some private lenders charge application fees and closing costs, but there are many that do not.

Private business loans and bank business loans are two very different financial products. The lenders that provide these financial options have different application and approval processes. The more you know about the pros and cons of the business loans available to you the more time you will save in selecting a lender, and the easier it will be to decide which product is right for your business.