Small business, big burdens: Online loans and the lack of transparency
More and more, transparency occupies the online lending industry spotlight—but it’s no highlight. The Federal Reserve’s 2016 Small Business Credit Survey found that half of all businesses were dissatisfied with online lenders due to a lack of transparency, while an overlapping half singled out high interest rates and unfavorable repayment terms. Unfortunately, some online lenders have combined “innovation” with a lack of transparency and expensive products that mislead small businesses. The result: bad deals and big debt.
After the crash of 2008, many banks pulled out of the small business loan market for amounts less than $250,000. In the years following, expensive online lenders (including cash advance providers) rushed in to fill this void with promises of speed and ease. While speed has improved and rates have dropped due to increased competition, pricing remains high among the largest players in the market, as evidenced by OnDeck’s 44 percent average APR per loan, which has shot as high as 99 percent. When you take into account renewals, where online lenders refinance their own loans before the term end, effective APRs for small businesses often rise to more than triple digits.
To make expensive products look reasonable, some lenders have introduced a term called total cost of capital. Although seemingly innocuous, this metric does not equate the terms of loans, making a short-term loan with a high monthly payment look like the right choice, while longer term loans with lower monthly payments look unaffordable.
This is the opposite of what is true. And it is obviously not transparent.
A tale of two (very expensive) loans
Here’s how the total cost of capital can trick a business owner into making the wrong loan choice:
- Choice A: If a business borrows $100,000 and pays back $150,000 over 12 months, their total cost of capital is 50 percent or $50,000.
- Choice B: If that same business borrows $100,000 and pays back $160,000 over 120 months, their total cost of capital is 60 percent or $60,000.
In this scenario, a small business may think that Choice A is superior and choose this vastly more expensive loan. By not equating the terms of the loans and clouding transparency, the total cost of capital metric effectively pushes business towards short-term expensive capital.
Instead, the way a business should calculate the actual cost of capital would be to equate the terms of the loans being compared. So, if Choice A is to borrow $100,000 and pay back $150,000 over 12 months, Choice B is superior—that is, to borrow $100,000 and pay back the loan early in only 12 months, instead of the full term of 120 months. (Pre-payment penalties can be factored in if there are any.)
This way, a business could find that with Choice B, they might only pay $110,000 in total, with an actual cost of capital of $10,000—and not the $60,000 that the total cost of capital metric would indicate. By not equating the terms of different loans, this new total capital cost may mislead the small business into taking a much more expensive offering.
Putting it all together: Getting past the debt trap
The State of Small Business Lending, a working paper published by Harvard Business School, provides information about how cash advance providers could be taking advantage of small business borrowers. That is: Choosing a short-term business loan with high monthly or daily payments can turn into a debt trap that’s difficult to escape.
When comparing loans, business owners should only rely on tried-and-true financial terms such as APR and monthly payment. If these terms are not disclosed in an easy-to-read, transparent manner, business owners who seek capital must demand to see these metrics—and have every right to do so. This leads to responsible, accurate borrowing decisions; banks publish the APR on their loans and so should online lenders.
When comparing options, businesses must be wary of tools that push them towards expensive debt, especially new “metrics” such as total cost of capital. Otherwise it’s too easy to fall into the clutches of a predatory lender. SBA loans are typically the least expensive debt a business can take on to build their business—and if a small business can get one, they should take it.
The owners of small companies work hard, and stake reputations, on turning dreams into viable economic realities. Online lenders that pursue high interest in the name of higher profits create a damaging deficit no APR can measure. Business owners need to stay aware, but those who give out the loans have an obligation as well. For in the final analysis, the spirit of ethical lending means lending small businesses a hand.
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