To a small business owner looking to expand in today’s tight credit market, many say their best shot at getting a loan is through a non-bank lender like an online lending company. But many are finding that the clean websites and seemingly simple terms some lenders promote hide the real cost of doing business.
Recent work by the Federal Reserve Bank of Cleveland and the Federal Reserve Board on alternative online lenders found that a focus group of small business owners generally liked the easier access to capital that online lenders provide compared with banks. But many were confused by the terms of lending offers, which can make it nearly impossible to determine if the loan is actually affordable.
The findings may act to help a growing national effort to regulate alternative lenders and expose predatory lenders. Federal Reserve data show that a little more than half of small businesses (those that earn up to $1 million in annual revenue) are denied a loan when they apply at a bank. Many turn to alternative lenders.
The drive to regulate the industry that observers estimate totals anywhere from $5 billion to $10 billion in annual loans is led by small business owners, industry lenders and nonprofit lenders. This summer, a coalition of those groups plus brokers and think tanks launched the Small Business Borrowers' Bill of Rights. The groups want to provide potential borrowers with the right to see an annualized interest rate and all fees. They also say that borrowers have the right to responsible underwriting so they don't take out loans they are unable to repay.
Participants in the Cleveland Fed’s focus group reported that they found lender websites appealing but had concerns about privacy. One auto dealership owner in New Jersey noted that lenders present their loans “in the most confusing way possible.” The websites are full of bright colors and testimonials from nice people, the owner added, but they don’t give applicants all the information they need.
When small businesses are looking for loans, they sometimes find, for instance, that an alternative lender may quote a 10 percent interest rate, but that may actually be a monthly rate -- meaning the actual annual percentage rate is 120 percent. It's a tactic often used by predatory lenders in the personal lending and cash advance markets. Sometimes the lender will demand a certain percentage of the daily sales of a business until the loan is repaid, a move that can make it hard for a busienss owner to make other needed payments.
“Many want information like interest rates, late fees and repayment penalties to be explained clearly,” said Ann Marie Wiersch, a Cleveland Fed senior policy analyst. “They don’t want to feel like they’re being taken advantage of.”
Participants also found product comparisons to be difficult because of the different ways lenders presented information in each loan term. They said they wanted clearly stated product features and costs and an easier way to compare. Still, they all liked the apparent simplicity of the application process. Banks usually require several years of tax returns and other data to be produced in-person, ask the owner to fill out long forms and take months to respond to a loan request. Participants like that online lenders make money available in days, often pull borrower tax data electronically and include non-traditional measures of creditworthiness like customer ratings on social media.
Jonathan Brereton, CEO of the nonprofit lender Accion Chicago, said the focus group study highlighted problems he sees “on a daily basis” with small businesses in the Midwest. “What typically happens is they think the [loan] is one thing and then realize later that it’s something else,” he said. Accion regularly deals with new clients who have taken out multiple loans and are unable to keep up. “Then follows embarrassment and a whole host of emotional responses,” Brereton added. “Trying to step in and help someone in the midst of that can be difficult.”
In addition to the borrower's bill of rights, which Wiersch said could be a rallying point for developing regulation, there has been other support on the federal level to expand small businesses’ access to capital. The U.S. Department of the Treasury’s Community Development Financial Institutions Fund (CDFI Fund) recently announced an additional nine bond loans, totaling $327 million that it was guaranteeing this year, bringing the total guaranteed to date to $852 million. CDFIs lend to low-wealth and low-income communities.
The Opportunity Finance Network, which is a coalition of CDFIs across the country, is issuing a $127 million bond to split between seven CDFIs targeting loans in Appalachia, metropolitan Chicago, Native American tribal lands, areas of New Jersey affected by Super Storm Sandy and areas of western Pennsylvania hurt by a decline in manufacturing. OFN is issuing an additional $100 million on behalf of a CDFI that focuses on rental housing and commercial real estate market in the West. The final $100 million will go to a development fund in Arizona focusing on senior living and long-term care facilities, daycare centers, healthcare facilities, rental housing, not-for-profit organizations, and charter schools.