March 17, 2016
Alternative lending is one of the hottest FinTech segments that attracts attention from the corporate sector as a logical continuation and source of potential clients. It also serves the goal of democratizing financial services for those who don’t qualify for a bank loan. Terms and conditions of alternative lenders seem to be more attractive as they employ various models, bringing down the costs of service and ensuring the best offer.
However, alternative lending has certain downsides that are often not mentioned. Some short-term advantages of alternative lending options may turn to long-term disadvantages. One of the details a regular consumer doesn’t often notice because of the sophisticated product presentation is an APR. While short-term interest rates offered by alternative lenders seem extremely attractive, the annualized rate often exceeds 100%. Since such APRs are illegal to pass onto the consumers of a loan, alternative lenders may use a loophole, which is avoiding classification of their product as a loan. In that case, the product and the interest rate can slip through the hands of the state and federal regulations.
The Federal Reserve Bank of San Francisco has explored the matter and brought an example of the state of California, where the state lending law applies to installment loans but it does not apply to cash advances, which are technically a purchase of future revenue for a fee.
The companies that don’t classify to be regulated, choose to disclose their rates in the cents charged per dollar borrowed instead of standard terms (APR). It covers the actual astronomical rate and makes it more difficult for individuals and businesses to estimate the potential expenses and make a fair comparison with other options.
Getting on hook with tailored to be attractive numbers, in a long-term, businesses often face the necessity to take another cash advancement to finance the previous one. This practice is called stacking. Stacking is a sign that a particular business is facing cash flow challenges. The problem of stacking becomes clear when a small business has to make several cash advancement payments a day, which may result in a quarter of their daily cash at the end of the day. When the cash flow becomes overburdened with previous loans, an entrepreneur would logically look for another loan. At some point, the business wouldn’t be able to obtain a loan because upon assessment for approval, the cash flow problem will come up. In the most dramatic scenario, the business will have to be shut down due to insufficiency of cash flow and stacked loans.
Another problem with alternative lending is that in some cases, these loans do not contribute positively to the credit score. Since cash advancement providers do not fall under the lens of a regulator, they are not obligated to report debts and repayments, which they sometimes don’t. WEF suggests an interesting reason to that – competition. Knowing that the list of borrowers can be purchased, alternative lenders do not wish to share their debt portfolio information because they know that the competitors may market their products to their customer base to stack the loans.
Some alternative lenders simply can’t report the debt and repayment information because their products are not classified as loans at all.
The lack of credit reporting is disadvantageous both for borrowers and for financial institutions. The first ones can’t contribute to the improvement of their credit history even if they repay the loan in a timely manner. The second ones don’t have access to the full information about the applicant that may have a good or bad credit history with an alternative lender. The problem is especially sharp when it comes to immigrants and their businesses. As they are often not qualified for a bank loan due to the lack of history with financial institutions in the country, they are forced to use the services of alternative lenders. And even if the experience is positive, they don’t get a chance to improve their situation with the corporate players.
Another problem with alternative lenders that is worth mentioning is the lack of transparency. The alternative lenders which aren’t regulated and obligated to report the portfolio contain potentially important financial data about the borrowers. The alternative lending industry is growing at a fast pace, and at some point, the lack of transparency may become an issue from the regulatory perspective when a significant part of the businesses will be able to operate in a shade.