How Alternative Lending Improved Small Business Access to Capital

How Alternative Lending Improved Small Business Access to Capital

Alternative lending has become increasing popular for many in need of small business capital even if they have bad credit history. It is business access to capital that gives the businesses the resources they need for to keep the lights on, pay their employees, purchase inventory, and expand their businesses. For decades, small businesses owners typically went to there local community bank to get business loans for the capital they needed. These banks were backbone of how main streets across the nation were created. However, the amount of community banks across this nation has fallen dramatically in recent years and intensive regulation since the financial crisis have made it more difficult for small businesses to acquire loans through traditional means, especially if the borrower has past bad credit history. Therefore many small business have had to resort to other means to get a bad credit business loan.

One private sector solution, alternative lending, has grown in recent years in order to fill this credit gap with use of online lending, It is estimated that private online lenders have funded up to $7 billion in small business loans since 2015.

Although funding programs vary from company to company, alternative lending sources typically offer smaller loans with no collateral and rapid approval and funding times.

Access to to small business capital is critical to the success of the small business however, obtaining a conventional commercial loan or a traditional line of credit can be particularly difficult for many small businesses when the business owner has a FICO score under 680. Lending requirements, are much tighter now than they were before the financial crisis and small businesses, especially startups are still considered a risky bet by many traditional lenders.

Federal Reserve Study
2014 Federal Reserve Board Study “The Impact of the Small Business Lending Fund on Community Bank Lending to Small Businesses”

In 2014 a Federal Reserve study found that only 8% of the small business loan applications would qualify for approval under current banking regulations. This number is much lower for those businesses owners with past credit history. It is believed the reasoning behind this is based on the challenges related to costs faced by banks. Banks under current policy undergo 28 different steps that can cost a bank up to $7,000 to complete one small business credit application. In addition, these banks have to spend money in time to review these small loans at an estimated cost of $1,000.

The Bad Credit Business Loan Credit Gap

Harvard Business School Study
Harvard Business School Study “The Decline of Big-Bank Lending to Small Business”

Harvard Business School recently conducted a research study called The Decline of Big-Bank Lending to Small Business  under Jeremy Stein, an ex Federal Reserve Governor along with two of his colleagues  and what they found was that fewer business expanded as the largest four banks pulled back in providing access to capital. Evidence provided in this Harvard Study shows that unemployment rates rose, wages fell and the effects were concentrated across many industries such as manufacturing. As a result, non-traditional finance companies jumped in fill that bad credit business loan gap.

Credit Quality of Small Business Using Alternative Lending

Bad Credit Score
Average credit score needed for business funding by Alternative Lenders is 420.

Industry experts and analysts agree, that we’ve seen the credit quality of business using alternative lending sources has improved from around 660 in 2016 to 670 in 2017. They have also seen that the amount of the loans that they’re providing small businesses, including those with bad credit, has increased from the average of $20,000 to around $65,000 in 2017. Online business lenders have also extended the length of their loans from very short term loans of up to 6 months to the now average of 15 months making it much easier for businesses with strained cash flow to operate successfully. We have also seen that longer more established businesses are taking advantage of the fast and simple loan funding processes provide by alternative online business lenders as well. According to other industry studies, 80% of small businesses that received funding from alternative lenders have improved their credit scores allowing them to climb the credit ladder and actually see their credit and financial health improve over that time frame. This is extremely good news for business owners who are also looking to improve their poor credit history.

How Alternative Lending is Improving Access to Capital for Small Businesses with Bad Credit

Alternative Lending Fintech
Alternative Lending, through innovative methods know in the lending industry as “Fintech”, is helping small business face the bad credit business loan gap in credit availability.

Alternative Lending, through innovative methods know in the lending industry as “Fintech”, is helping small business face the bad credit business loan gap in credit availability. Small businesses need choices when it comes to getting the capital they need to grow when they need it.

Small business also benefit from having different types of financing available when a business owner who is planning for a longer term capital needs. Currently the Small Business Administration (SBA) provides for guaranteed small business loans through traditional banks and these low-cost business loans can range from $25k up to $5 million. However, in order for the applicant to get approved, the business owner must typically submit a business plan, and often put up large amounts of collateral such as a home or commercial property. These lower credit business loans can take on average 60 – 90 days before funding is available. If a business owner requires fast, short term access to capital, they can apply from an alternative lender or apply to sell back an portion of future receivables to receive a Merchant Cash Advance (MCA). These types of transactions are not actually considered loans by legal definition, and tytypically include higher repayment costs. If the applicant has past bad credit, the applicant typically must submit bank statements showing a few months of the business’s revenue, and then the business can receive funding in a matter of a few days.

Be that as it may, which ever type of  business financing a business owner chooses, traditional banks alone are not addressing the needs of small businesses customers, especially those with bad credit. The small businesses demand for fast and easy business funding is the primary reason that alternative lenders are finding such success in the business lending space .

Current Market of Bad Credit Business Loan Options Available to Small Businesses

Bank Traditional Lending
Traditional bank loans to small businesses remain the primary source of financing for small businesses, in part due to familiarity.

What is Traditional Lending?

Traditional bank loans to small businesses remain the primary source of financing for small businesses, in part due to familiarity. Because of the localized nature of local banks, a relationship is often formed with their small business customers and may agree to underwrite a business loans for them. In some cases, traditional bank business loans have some advantages. Using online tools provided by banks, a mall business owner can compare available business loan options, and terms against other loan programs or other competing banks. This allows the business to be able to define the maximum cost of the loan to the business. Additionally, traditional business loans can some times have flexible repayment terms of between 3 – 10 years. Most importantly, the SBA provides guarantees with adds additional incentive and security for banks, and increasing small businesses access to traditional lending.

Even though traditional banks have tried to provide better access to financing for small businesses in recent years, traditional business loan lending still continues to suffer from many short falls. Thus the average small business owner still finds tradition bank lending as either inaccessible or impractical. As a threshold issue, qualifying for a traditional bank loan can be very demanding and time consuming process for many small business owners. Most small businesses often do not have the required financial statements or assets that can be put up for collateral to secure these types of business loans. Even the perfect business loan applicant would need to show a lengthy history of records including profitability and performance, but in the real world, many small businesses have neither. Traditional lending also comes with many risks over alternative lending.

Traditional Lending Risks

Further more, traditional bank business loans are absolutely repayable. This means the collateral that was put up to secure the loan including business assets such as real estate, or even the home of the business owner can be at risk during the whole term of the loan. As a result, a business owner that defaults on a traditional business loan can be at substantial risk for bankruptcy.

Banks are also concerned about the risks of lending to a small business with bad credit. In today’s current lending market, regulators heavily scrutinize banks, and as a result, lenders are very cautious about extending their amount of debt. As a direct result, traditional banks have dramatically reduced the amount of money available for borrowing by small businesses, heightened their collateral requirements, and increased the credit score requirements of small business borrowers. In 2013, over ninety percent of business loans under $100k required secured collateral which is up 84 percent since 2007. Regulatory risks are not the only issue facing traditional lenders from providing bad credit business loans, or any commercial loan. The loan underwriting costs which include careful review of the borrowers personal and business financial records as well as the applicants business plan on how they will use the loan, have sky rocketed in recent years. Thus, the cost of processing a loan for a bank is nearly the same regardless of whether the loan application is for $5 million or $5k.

Speed of financing is still one of the biggest issues that face business owners who look to acquire funds from traditional lenders. Even highly qualified business borrowers still face difficulty finding capital in a reasonable time frame. Several Federal Reserve banks conducted a survey which produces data indicating the average small business owner can spend up to 72 hours consulting with banks, completing out loan applications and producing all the required records and additional documentation needed. This data from this same survey also seems to indicate that many small business owners are willing to pay a higher price for alternative lending sources in exchange for a simpler application process, quick approval and fast availability of the funds needed.

What is Alternative Lending?

Alternative Lending
Today, compared to the lengthy process of finding a traditional loan, most business owners can quickly find alternative lending sources on the internet, where they can also apply online and receive an approval in just a few hours.

In recent years, alternative lending has directly addressed the small business funding needs by providing quicker access to needed capital over traditional lending providers. Today, compared to the lengthy process of finding a traditional loan, most business owners can quickly find alternative lending sources on the internet, where they can also apply online and receive an approval in just a few hours. It is because of improved technology and innovation by private lenders that the lending process has been automated which makes the application and approval process for business loans much more efficient and less burdensome to the business owner. Utilizing complex algorithms and the availability lending data from a wide range of sources, alternative business lenders are able to lower their risk factors and ultimately provide financing faster and a lending process that is much more streamlined than a traditional bank.

Alternative Lending Risks

Non-traditional loans also have some disadvantages. Education of the business borrow on the type of different private funding programs available over the term bank business loans they already understand has been met with challenge. The convenience of alternative lending programs also comes at a higher cost to the small business over a traditional bank business loan. Some small business owners that don’t fully understand the terms of the lending programs, just as with traditional lending, may find defaulting on a loan buts the  the entire business at risk.

What is Factoring?

Simply stating, factoring is the purchase of a businesses receivables at a discount to the lender. Many businesses have used factoring when financing for hundreds of years. Here is how factoring works: A small business that needs access to capital is made an offer by an alternative lending provider for funding, and in return the lender purchases receivable income from the business (ex: new invoices). In this example the lender is called the “factor”. This type of business financing most typically comes with payment terms from 30 to 60 days.  The lender will that pay the borrower upfront to buy the invoices at a discount. This allows the small business to obtain the funding they need at a very quick rate.  The factor also takes the credit risk in the instance that the small business’s customer cannot or will not pay the invoice. This type of financing is particularly beneficial to business applicants who have bad credit history in their past because the approval decision for the loan is based on the financial ability of the business and less on credit scores. While traditional lenders require high FICO scores and collateral to get approved for a business loan, private non-traditional lenders will overlook credit blemishes and accept borrows with bad credit if the business in in good financial health.

Is Alternative Lending for a Small Business Loan Safe?

Alternative Lending Regulation Compliance
Alternative Lending is relatively safe since the industry is sufficiently regulated by existing federal and state laws.

Alternative Lending is relatively safe since the industry is sufficiently regulated by existing federal and state laws. Both alternative and traditional lenders must comply with laws and regulations affecting nearly every aspect of their transactions including marketing, underwriting, servicing and collections. In additional to the compliance of every state and federal law, alternative lenders are under the scrutiny  of the very powerful Federal Trade Commission (FTC) which has the authority to prevent misleading, unfair or deceptive lending practices. There is also a law called the Telephone Consumer Protection Act26 and another called the CAN-SPAM Act27 which restricts the type of telephone and email communications that can be used during and after business-purpose transactions are made. The FTC wielded its powerful authority in 2014 to protect small businesses from providers that may be technically complying with the the law but which are still engaged in otherwise harmful practices.

 

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