SMEs Distrust Banks, But They Distrust Alt Lenders, Too

From high-profile IPOs to big-ticket venture capital commitments, the alternative lending industry could soon be worth $1 trillion. Boosted by small businesses in need of funds and banks that remain overly cautious after the financial crisis, alternative lenders have fundamentally changed the way small businesses seek capital. The rapid rise of alt-lending may be hiding a not-so-pretty secret—hefty fees and hidden costs.

About half of small business loans originated through online platforms begin with brokers, according to Forbes. For borrowers, navigating the labyrinth of potential lenders can be complex. An Internet search for “small business loan” returns over 1 million results.

Brokers position themselves as middlemen, helping borrowers find the loan that best suits their needs and brings potential clients to lenders’ doorsteps. In exchange, they receive a fee. Fees can rage from a modest 1 to 3 percent—brokers earn just 1 to 2 percent on Small Business Administration backed loans—to high double digits. A broker agreement obtained by Bloomberg showed a lender expecting to be repaid 14 percent above the amount advanced on a loan with a six-month term. On top of the 17 percent preferred brokers can tack on, a borrower could be facing 31 percent in fees in addition to the cost of the loan. In real numbers, a $30,000 loan could cost an owner $39,300, with the broker pocketing more than half of the effective interest rate. The totality of the fees are often undisclosed until borrowers are through the application phase and ready to sign for the loan.

Not everyone sees broker fees as a problem. David Goldin, CEO of lender AmeriMerchant and president of an industry trade group called North American Merchant Advance Association, told Bloomberg that most “reputable companies” limit brokers to adding no more than 12 percent of the loan amount in costs. Adding the fees helps independent brokers who can struggle to break even after the expense of advertising and other costs is considered.

Despite the growth of alternative lending, some business owners are still on the sidelines. Just over 40 percent of owners said they did not trust alternative lenders, according to a recent report from SurePayroll. Whether or not the mistrust comes from high fees, lenders have work to do.

Alternative financing has changed the way small businesses seek capital, challenging the traditional stronghold of banks. Yet, non-bank borrowing represents a small percentage of business loans. Data collected by the Harvard Business School reveals alternative lenders, including balance sheet lenders, lender agnostic platforms and peer-to-peer platforms, have granted $7 billion in loan capital as of 2013, a sliver of the more than $500 billion in bank loans granted in the same time period. Unlike bank-based loans, alternative lenders are experiencing rapid growth. Most lenders surveyed by Harvard registered triple-digit growth year-over-year. The growth in lenders is matched by borrowers. Just 11 percent of business owners polled by SurePayroll have used alternative lenders, but 38 percent would consider using one. Borrowers who do go the alternative route are pleased with their decision, as 84 percent had a positive experience and said they would use an alt-lender again.

Hidden fees aren’t limited to non-bank lenders. In the United Kingdom, fees attached to another popular short-term finding option—invoice financing—add £425 million ($640 million), in extra charges every year.

For lenders, finding creditworthy borrowers is tough. For borrowers, selecting the right lender can be tricky. Brokers, and their fees will likely continue to be a part of alternative lending. Many lenders are working to distance themselves from brokers. Their market share is on the decline, down to 50 percent from a high of 70 percent a few years ago, Forbes reports. Online marketplaces are challenging brokers’ dominance. Marketplaces such as Fundera and Buynance aim to directly connect borrowers and lenders. According to Bloomberg, both charge fees that top out at 3 percent of the loan amount on par with modest broker fees. Fundera’s founder Jared Hecht points to the power of the Web, telling Forbes “In other industries, the Internet replaces the broker.” The broker is still a fixture of small business lending—for now.