Lending business has steadily been one of the most lucrative in FinTech for almost every party involved - virtuous investors and talented teams alike. In fact, lending is one of the two most funded and represented segments in the FinTech industry, which counts close to 8K startups globally. With an estimated $29.1 billion in online loans originated in the US market by alternative lenders in 2015 alone, marketplace lending has emerged as one of the fastest-growing areas of the credit universe.
Undoubtedly, lending startups serving the small business community deserve the credit they get: they introduced new business models, expanded into unique financial products, reached unprecedented speeds of approval and funding, took underwriting automation to the next level, expanded financial access to more borrowers, and redefined security with technology-focused lending solutions.
“Small business owners are experts at what they do but don’t have the time to be financial experts. FinTech is helping SMBs become better-qualified. Financial institutions can get better applicants and make more accurate and faster decisions, reducing underwriting costs. Platforms that are attached to real-time, 360-degree data on the health of a business can make underwriting a real-time decision – not a snapshot in time. I believe the business loan application will die in the not-so-distant future. Loan approval becomes the consequence of healthy business operations. It connects all the data dots and takes care of “last mile delivery,” a pain point of underwriting a loan,” shared Janet Zablock, the former Head of Global Small Business at Visa [Janet officially left Visa on May 1st of 2017], and currently, an Independent Board member at Nav Inc., in a recent interview with the LTP Team.
The “Wild West” of SMB lending
We could argue that it would have been just a matter of time for banks to reach the same place, with them adopting technology and innovation at an accelerating pace. What significantly contributed to proliferation of SMB lending startups is the a gap in access to credit for small businesses that existed for a long time and has been particularly persistent in small dollar loans — those defined as under $250,000, the level of loan that most small businesses want. More than 70% of small businesses seek loans in amounts under $250,000, and more than 60% want loans under $100,000, Karen Gordon Mills, Harvard Business School, and Brayden McCarthy, Fundera, Inc., found. In fact, “Of the 28 million small businesses in the United States, over half faced financial challenges in the last year ,” emphasized Zablock.
According to the study called The State of Small Business Lending: Innovation and Technology and the Implications for Regulation, the entrance of alternative lenders attempting to fill the market gap in small dollar loans began as early as the late 1990s with the introduction of merchant cash advances, and later short-term loans. The market has evolved with the arrival of players like OnDeck, Kabbage, Funding Circle and others in late 2000s, with technology playing a key role in rapid loan underwriting using new data sources, such as current bank account information and real-time cash insights.
“As the market grew, the number of new firms entering the space multiplied quickly, spurred on by high interest from the venture capital community, and large inflows of capital for loans provided by investors who were attracted by the higher interest rates of these products versus low yields available elsewhere in the market. These factors fueled explosive growth in the sector and led us and others to call the environment of this period from 2014 through early 2016, the “wild west,” Mills and McCarthy continue.
The “wild west” in SMB lending had a great promise in the beginning. What could go wrong? Turns out, there are quite a few important implications to a seemingly genuine attempt to solve the biggest problem for small business owners:
- High costs. Lenders commonly charge APRs above 50% and can easily reach over 300%.
- Double dipping. Repeat borrowers incur additional fees each time they renew their loans.
- Hidden prepayment charges. Unlike traditional loans, many alternative lenders require payment of the full interest even when loans are repaid early.
- Misaligned broker incentives. SMB loan brokers often recommend the most expensive loans because they earn the highest fees on those.
- Stacking. Multiple lenders provide loans to the same borrower, resulting in additional and hidden fees.
Moreover, the Federal Reserve study found that satisfaction levels are highest for applicants at small banks and lowest at online lenders. Successful applicants at small banks were the most satisfied with their experience. Online lenders and large banks both had much lower net satisfaction scores. Unfavorable repayment terms and high interest rates were common reasons for dissatisfaction with online lenders. Transparency issues were cited across all lenders. 31% of firms dissatisfied with their experience pointed to a lack of transparency.
Let’s talk about the APR
I’d like to go back to the most interesting part - the APR, which essentially comes down to how a lender sources the funds to secure the credit, and, at the end, is the foundation of a competitive product. Here is how it works: Cost of funds is driven by the interest expense, fees and amortization of deferred issuance costs that a lender incurs in connection with making loans - the “cost of funds rate,” which is calculated as a lender’s funding cost divided by their average of the funding debt outstanding at the beginning of a quarter and at the end of that quarter.
A bank’s cost of funds for short-term loans is determined by two sources of funding:
- The Federal Reserve’s discount rate, which is charged to commercial banks on loans received from their regional Federal Reserve Bank’s lending facility (~1%).
- Retail deposit bases, which offer access to additional quick, stable and inexpensive sources of capital.
By contrast, the HBS study emphasizes, online lenders bear costs of funds that are significantly higher than those of a traditional bank.
“Established online players bear cost of funds of 5-to-8 percent. Less established alternative lenders bear a cost of funds that can run as high as 15 percent. (The exception to those with high cost of funds are the ecommerce platforms and payment processors who tend to generate low-cost cash in the base businesses.)”
I’d like to bring up an interesting example (there are quite a few, emphasizing similar issues) without pointing a finger at anyone in particular (that has already been done by the source). A well-known online lenders’ website states that term loans of up to $500,000 can be obtained with annual interest rates as low as 5.99%. However, when contacted by the potential borrower, the lender did not seem to be able to offer such a favorable rate. The result: a 12-month, $65,000 loan, plus nearly $17,500 in interest and an origination fee of $1,625. That translated to an APR of 55% (the lender promises that its average annual interest rate for term loans, excluding fees, is 38%.)
Quick access to cash comes at cost
“In principle, FinTech lending platforms have the potential to offer lower interest rates to borrowers and/or higher returns to investors (after including user fees). The intensive use of digital technologies reduces operating costs for credit intermediaries by removing the need for physical branch networks and allowing heavy (or full) automation of loan application, credit risk assessment and pricing processes,” the Bank of International Settlements (BIS) fairly notes.
However, quick access to cash always comes at cost. Short term loans tend to conveniently mask the APR, leaving a gap in understanding of the total dollar amount to be paid as an interest (aside from high origination fees). As a result, what seemed like a Philosopher’s Stone can turn into a Trojan Horse for uninformed small business owners. For online lending to be different from legal sharks, it should be the lender’s responsibility to transparently communicate the rates and provide data/resources necessary for an informed and safe business decision.