Communicating the Cost of Capital in Alternative Lending

Brock-Blake-Lendio

[This is a guest post from Brock Blake. Brock is the Founder and CEO of Lendio, a marketplace for small business loans.]

Born out of the critical need for capital created by the great recession, in less than 10 years the alternative lending industry is estimated to grow into a $1 trillion industry (Charles Moldow, “A Trillion Dollar Market: By the People, For the People.”).

Many of the new business financing products have a higher than average cost of capital in order to service businesses with higher risk profiles, who can’t qualify for conventional SMB loans.

While most applaud the new-found access to capital that is provided through these new lenders, critics of this young industry say that the higher costs put undue stress on SMBs and will end up hurting them. On the other hand, advocates say that even though the costs may be higher, these loans still help SMBs start, maintain and grow their businesses.

This heightened scrutiny puts alternative lenders in a precarious position: how can they assist SMBs with needed capital while not pushing struggling businesses over the edge with unrealistic debt obligations?

I firmly believe that the overwhelming majority of alternative lenders are providing benefit to borrowers, but it’s also clear that SMBs may not be fully grasping the cost of capital, and that the communication gap between lender and borrower may be fueling doubts regarding the intent of the alternative lending space. This is why the alternative lending industry needs to move to close the communication gap between lenders and borrowers, and to do so by using all relevant metrics to articulate the cost associated with a loan as clearly as possible.

Here are two questions lenders need to consider to effectively communicate the cost of capital.

1. Does this loan provide benefit to the borrower?

Specifically, what does the business owner need the money for, how quickly do they need it, and will the financing improve the borrower’s situation?

The borrower’s situation is important for several reasons. First, the only way for an SMB owner to evaluate the cost of capital is to consider it against the cost of NOT getting capital: what is the cost of not bulking up inventory, or of not making a critical hire? If the upside from getting the capital in a timely fashion is just incremental, the cost of capital needs to be considered carefully to make sure that the benefits outweigh the limited upside. On the other hand, this could be less of a concern if the upside is significantly greater than the cost.  Second, borrowing money for cash flow for several weeks or months is very different from taking out a loan that will be paid back over years and is secured by an asset that can be sold (which is why credit card rates are so different from rates on mortgages). What’s most important to a borrower who needs an infusion to help manage a temporary cash flow situation is not the same as what’s important to a borrower investing in heavy equipment that will depreciate as it’s paid for over years. And third, while we’ve all heard the truism “time is money,” to an SMB owner that may literally be true. The flexibility to act on an opportunity or implement a strategy in a timely fashion may pay for itself in the short or long term.

Fortunately for the business owner, the alternative lending industry has opened a whole new world of loan options to help solve the cash needs of the business that owners didn’t have access to previously. These products not only help smooth cash projections, but SMBs are also able to seek funds on short notice when they find themselves in a cash crunch. The flexibility and the speed at which these loans can be funded is an important need that the alternative lending industry is meeting. While the typical time for a business to obtain funds through traditional lending sources is 60-90 days, alternative lenders are able to provide funding in 2 to 10 days. That being said, it is critical that the lender take the time to understand the borrower’s situation and priorities — learning about what’s most important to him or her.

2. What loan terms are most relevant and beneficial to the borrower’s situation?

A couple of weeks ago, I was on a call with another key player in the industry when he asked me, “Does Lendio always recommend the lowest APR product to the business owner?”

He was shocked when I responded with “no.”

Most would think that the lowest APR product is always the best loan product for the business owner. However, that’s just not the case. Sometimes, the best product for the situation of the business owner is the largest loan size. Other times, the best product for the borrower’s situation might be the most collateralized, lowest payment, or even quickest to fund. The point is, the borrower’s situation should drive the type of loan product, not (necessarily) the lowest APR.

Here, a concrete example will help. Consider these two loans:

loan-comparison

Most people are familiar with APR. While its goal is to standardize the cost of capital in order to allow borrowers to compare different loans, loan structures differ and when they do, APR may not best represent the true cost of a loan.

Consider a SMB seeking working capital to meet a sudden increase in inventory demand for the next few months. If the SMB was presented with the two options above, but only given APR and Loan Term as data points, they would likely be wary of accepting loan #1 even though it has less than half the Total Dollar Cost and better fits the situation in which they plan to use the loan. The fact is that for business owners with short-term needs for working capital, it often makes sense to choose shorter-term loans over longer-term options even though loans with a term under a year will show significantly higher APRs.

This comparison reveals the challenge that’s created when the cost of capital is expressed only through one metric. While APR can be the best way to compare the cost of credit on a long-term loan such as a car loan or mortgage, it may not be the best way to show the true cost of capital on a small business loan.

One Size Does Not Fit All

Today, the alternative lending industry offers a dynamic set of loan products including term loans (both traditional and short-term), business lines of credit, loans for startup companies, equipment purpose loans, various SBA loans, accounts receivable financing, merchant cash advances, and peer-to-peer loans. The variety enables SMBs – including those who may have lackluster credit scores or lack sufficient credit history to qualify for conventional loans – to find loans that can best fit their situation. Compared to 2009, this is a great place to be in: capital is generally available, and in a variety of forms, and not just for those with pristine credit; lenders have devised products for businesses with less than perfect credit as well. In this new, more complex world, we’re all struggling with how best to communicate the true cost of credit to SMB borrowers, so that they can make informed decisions that keep their businesses healthy and growing. Rather than taking a one-size-fits-all approach, we need to recognize and consider each borrower’s individual situation, and which data points are most relevant to them.

Subscribe
Notify of
16 Comments
Oldest
Newest Most Voted
Inline Feedbacks
View all comments
Makesomesense
Makesomesense
Mar. 30, 2016 10:38 am

#2 while correct in math is a horrible point. Almost pushing Lendio short loan agenda. How does that make sense? The business effectively has to generate 22K in 6 months for the lender. Ok. That velocity alone is a backbreaker. The 27K – while 5K higher – is payed over 5 years. oh anaverage monthly payment on loan #1 is something like 730.

Sorry its not a challange. Longer duration loans reduce burden on cash flow.

Thanks for the marketing though.

Brock Blake
Mar. 31, 2016 6:30 pm
Reply to  Makesomesense

You are right. Longer term loans reduce burden on cash flow. However, the reality is that many small businesses need access to short-term capital and cannot qualify for or wait for a traditional/SBA loan. We need to provide clarity and ensure there is benefit to the borrower. Thanks for the comment.

Brock Blake
Mar. 31, 2016 8:49 pm
Reply to  Brock Blake

Additionally, the scenario that we used was only provided as an example to show that neither APR nor Total Payback fit in every scenario. With longer term loans (longer than a year), APR is much easier to understand. However, with loans shorter than a year, APR is confusing and makes it difficult to truly evaluate the cost of the loan. At the end of the day, the most important takeaways are that 1) lenders adequately assess if loan provides benefit to the borrower, and 2) lenders present the loan in a format that is clear & understandable.

Confused
Confused
Apr. 1, 2016 8:18 am
Reply to  Brock Blake

This is a confusing response. In the article the example provided seems to convey why you, a broker (not a lender), would recommend a product with higher APR when a customer is presented with another offer at significantly lower APR. Your example does not make it seem like it’s an issue that “lenders adequately assess if loan provides benefit to the borrower,” but an issue that you, a broker, adequately assess if one loan provides benefit to the borrower relative to another loan. My takeaway of the article through the use of your example is not that a lender should help the borrower get the best loan (they’ll always want to sell their loan even if it’s more expensive than someone else’s), but that it is the responsibility of the broker to help the business owner make this decision.

Under the scenario you provide in the article, the only reason I can deduce that someone would encourage a borrower to take #1 is that the broker makes a significantly higher commission (probably ~10%) versus option #2 (probably 2-3% based on my knowledge of the industry). With #1 a broker would make $1,800, but with #2 the broker makes $360-$540; however, #2 saves the borrower thousands of dollars if they prepay and is clearly the right thing to do for the business owner for all the reasons highlighted in the comments section.

So either the example in the article is a big mistake (and there probably are different examples that would have better supported your point), or it isn’t and when you read between the lines it highlights the incentives of why someone would use this type of logic in this situation to help themselves as opposed to helping the borrower.

Maddy
Maddy
Mar. 31, 2016 9:32 am

What a horrible analysis. This not even talks about the early payment penalty. The best course of action will be take loan #2 and pay it early in 6 months. But online sharks have no early payment clause that is not aligned with the borrower.

Brock Blake
Mar. 31, 2016 8:39 pm
Reply to  Maddy

You’re right. If the lender from Option #2 allowed for pre-payment, that would definitely be the best of both worlds: a lower monthly payment in the short-run AND the ability to pay off the loan before years of interest accrued.

That leads me to another point… if the lender is doing their job to make the terms clear and understandable, they should also inform you as to whether there are options to prepay (or not).

What?
What?
Apr. 1, 2016 8:53 am
Reply to  Brock Blake

What lender that offers a 5 year term loan with monthly repayments would not allow you prepay without penalty?

Maddy
Maddy
Apr. 3, 2016 8:30 am
Reply to  What?

No one! That’s why Mr. Blake doesn’t show up in the example above!! What they care about is their broker fees and how to stack.

Fred93
Fred93
Mar. 31, 2016 3:04 pm

Horribly misleading.

By the way, I tried to verify the APR of that #1 loan, and I get 137.03%, not 83%. Has anyone else tried to verify this calculation?

Nick
Nick
Apr. 1, 2016 12:14 am
Reply to  Fred93

I ran the numbers on #1 but came up with a different number altogether. I think the error is in total cost of capital, which should be $4,500 vs. $4,016. With 22% simple interest, interest paid would be $3,960 plus the $540 origination fee.

APR
APR
Apr. 1, 2016 6:10 am
Reply to  Fred93

I’m getting ~96% APR on Loan #1. Perhaps the author confused APR with effective interest rate.

While I agree that APR in small business lending is not the be-all-end-all solution for evaluating whether or not to take one offer over another (e.g. total cost is important as well), it is a critical data point in comparing offers across different products.

The example provided here is fundamentally flawed, and incredibly scary if this is the approach a company takes while justifying pushing business owners into short duration loan products when they are eligible for longer duration, lower cost capital. If a business owner were eligible for both these products and only needed short-term working capital, they should undoubtedly take the 5 year loan and pay it down after 6 months (unfortunately, as someone noted above, most short term lenders have prepayment penalties which is discouraging for borrowers).

If the business owner accepted the 5 year term loan and paid it down after 6 months (because as the author says, they may only have the need for short term working capital), they would save $2,351 relative to taking out the 6 month loan option. My math is that if they prepay after month 6, they will pay $1,665 in interest to the lender. If they take out Loan Option #1 the total cost is $4,016. To make matters worse, within 3 months the business owner will have less than 50% of the principal loan amount to work with, whereas under #2 they will have 92% of it remaining. Also, the origination fee on #2 is half that as #1. This is a no brainer.

Mowgli
Apr. 1, 2016 8:37 am
Reply to  Fred93

I think comments by those who calc their own APR exactly prove the point of this article: APR is hard to understand.

Those who think they can calculate APR with the given information have to make two assumptions not given in the article: 1: what the nominal interest rate used was, and 2: the number of weekdays in the 6-month period. Without this information you can’t calc APR. So their APR figures can in fact be verified if you make the right assumptions. The math checks out.

PS: Some have use the “For every dollar borrowed you pay” field as the nominal interest rate to calculate APR which is a flawed assumption. That field includes the compounding and origination fee.

Interesting article and definitely thought provoking. Especially since the comments show how misunderstood APR is with everyone coming up with their own APR.

That being said, I still think short term loans put too much pressure on businesses. If they can qualify for a different loan they should take it.

Makesomesense
Makesomesense
Apr. 1, 2016 10:10 am

Read all the comments. Great points pointing out the flaws of the article.

I run a business. Will never take loan #1. While we are at the topic, everybody is in it for the money (duh!). This whole BS about helping business – yea, no one is helping business.

Nothing against lendit conference or Peter who is a great guy, but the finance people I met on my last lendit were terrible human beings in the sense that they all have their own agenda and I couldn’t garner any human sympathy or any “human-ness” from them.

Alot of these guys remind me of Big Short brokers/lender. Whatever, I’m glad I understand these things, many of my close friends in business just get obliterated under heaving MCA interest.

Mowgli
Mowgli
Apr. 1, 2016 10:11 am

Those who have commented on their own APR calc kinda prove the point of the article: APR is hard to calc and misunderstood.

In doing your own calcs you need to make some big assumptions: 1) what the nominal interest rate is 2) how many weekdays are in the 6-month period. Neither of those numbers are given in the example. If you make the “right” assumptions on those numbers the APR checks out and the math is good.

PS: don’t confuse “for every dollar you borrow, you pay” with the nominal interest rate to use in your APR calc becuase its not the interest rate. It should include compounding and fees.

Overall, thought provoking article. The varying APRs in the comments prove the point. However, I still don’t like short-term loans. Borrowers can do better if they can qualitfy for better loans.

George
Apr. 3, 2016 12:37 am

There are some good points here and appreciate you taking the time to write about your thoughts but personally, the second part of your post suggests how out of touch you likely are with small businesses. The dry-cleaner next door isn’t looking at the APR when making the decision to stay afloat for the foreseeable future. As a son of a small business owner, I can relate to the borrowing decision making process. Everyday we speak to these business owners who have different struggles and priorities. Looking at APR is not one of them. But that’s just my opinion.
I do suggest conducting some street surveys and figuring out what matters most will help your business further.

Observer
Observer
Apr. 4, 2016 6:48 am

If the dry cleaner needs money to stay afloat this is a moot point because he wont be offered loan #2 as his business will be deemed too risky. What many people fail to realize is that most business owners aren’t choosing between these options. Obv if you can get loan #2…take it. But it’s really hard to get a long term, low rate loan. So the better question here is should loan #1 be available at all.