The Cost of Money: What Is Your Business Really Paying for Fast Funding?
Traditional business loan applications are lengthy and invasive. Additionally, they can require you to jump through hoops set by conservative bank managers. In response, a number of online lending institutions have established themselves as easy-to-access substitutes for business owners who can’t qualify for traditional bank loans or who need their money in a hurry. These establishments are often referred to as “online lenders” or “alternative lenders.”
Online lending isn’t a new industry, as some online lenders have been around since the early 2000s. Common alternative lending solutions include merchant cash advances, peer-to-peer lending, and invoice factoring. These lenders are more lenient than traditional banks when it comes to credit history and they take an expedited approach when it comes to loan approval. In some cases, business owners may apply for and receive funding on the next business day without ever visiting a branch.
Although there are other variations, these loans have one thing in common: users will be approved quickly and will need to repay the loan in short order. While quick funding and ease of approval may appear beneficial, they come at the cost of high-interest rates and opaque terms.
Easy access to funding is a double-edged sword. If businesses rely on these types of loans too much, the costs can quickly grow to outweigh the benefits. Short-term loans should be used sparingly to cover emergency expenses and cash flow shortfalls.
Now, let’s evaluate some of the costs you’ll encounter when trading cash for speed.
High APRs and Factor Rates
Nobel Prize-winning economist Milton Friedman noted that there’s no such thing as a free lunch; this concept also applies to business lending. Many alternative lenders advertise relaxed lending standards and quick funding. In exchange, they often charge high-interest rates, sometimes with APRs as much as 60% higher than retail banks.
Not all online lenders advertise their rates as APRs. Some lenders quote their interest expenses using factor rates or “fixed interest charges.” This is common for invoice financing and merchant cash advances. Traditional amortizing loans, like mortgages or student loans, incur interest over time and are paid off gradually in fixed installments. If you’re able to pay off your loan early, you save money on interest. By contrast, factor rates charge the full interest amount upfront, which eliminates any interest savings from prepaying and creates an unavoidable expense.
To best gauge your expenses, rates on different loans should be compared using APRs, which annualize your interest expenses. This allows for an apples-to-apples comparison between loans. If you’re not sure how to calculate your APR, there are a number of online calculators that can help you. After converting factor rates to APRs, it isn’t unheard of for your converted interest rate to reach as high as 130% or more.
Most of us are familiar with paying loans on a monthly basis, however, many short-term business loans require weekly or even daily repayment schedules. This restricts your cash flow and hampers your ability to access cash when you need it. For some loans, you might even be signing away part of your daily credit card sales until the loan is paid off.
A common loan product that may require daily repayments are merchant cash advances, which take a percentage of your daily credit card transactions as repayment. Cash advances aren’t regulated to the extent that traditional loans are. Usually, laws limit your maximum borrowing rate to 36% depending on your state or loan amount, but this isn’t the case for cash advances. While a small percentage of your daily transactions may seem small, this can add up to dozens of percentage points when converted to APRs. When shopping for financing, it’s always a good idea to ensure that you’re comparing all of your lending options on an apples-to-apples basis.
Entrepreneurs usually have a knack for recognizing good deals when they see them. However, alternative lenders aren’t always known for their transparency. Due to a lack of formal regulations governing alternative business loans, many online lenders aren’t legally required to disclose their rates on their websites. Consequently, they may not specify your loan terms until you submit an application and consent to a credit check.
Some lenders will play coy when asked about their interest rates over the phone. So it’s important to fully understand your loan terms before committing to a loan. Read a few lender reviews before applying with an online lender, as the authors will have taken care of some of the legwork when it comes to sourcing information. At the end of the day, online lenders are businesses trying to turn a profit (albeit some more unscrupulously than others). It’s therefore critical for borrowers to fully understand the nuts and bolts of their agreements to avoid surprises later on.
From time to time, it may make sense for your business to explore alternative lenders, particularly when it comes to unexpected emergency expenses. Businesses without sufficient credit histories may have an easier time qualifying for alternative loans, as online lenders often conduct holistic reviews of your financials instead of relying exclusively on your credit score. Alternative lenders may weigh your ability to repay debts more important than your credit history and can offer access to cash when your business needs it most.
Alternative lenders have their place in the business lending ecosystem. However, entrepreneurs should understand that convenience and leniency will always come at a cost. Just like any other financial instrument, alternative lending is a powerful tool that should be employed responsibly. Do your diligence on both the lender and the loan before accepting what seems like “easy” financing.