Do you have a clever business idea but lack the resources needed to start your company? Or, maybe you have an existing small business and need financial assistance to grow your firm? Fortunately, there are several options available to help you meet your business needs. Historically, business owners have sought out traditional banks for their borrowing needs. However, many small businesses have faced stringent criteria preventing them from securing a bank loan. According to Forbes, big banks approved only 27.3% of small business loan applications in March of 2019. To close the capital access gap, alternative lenders or “FinTech” companies, have emerged with an approval percentage of 57.3% during the same period. In this blog, you will get to know about Fundmerica on Banks Versus Alternative Lending: Which is Best for Your Business.
Alternative lending is any type of lending that occurs separately from a traditional banking institution. “Alternative lender” is an umbrella term that accounts for numerous financing models, including direct private lending, marketplace lending, and crowdfunding platforms. These firms have discovered a successful approach for leveraging technology to provide fast and reliable financial products to businesses around the world.
Fundmerica, a financial company that helps small business owners get the funding they need, outlines several of the key differences between traditional banks and alternative lenders to help you decide what route is best for you.
The most important question a lender considers when deciding if they will approve a small business loan is whether the company will be able to repay their debts.To answer this question, banks evaluate your personal and business credit scores. The largest component of your credit score reflects your ability to repay debts in a timely and consistent manner. These obligations can include mortgage payments, car loans, credit cards, and other financial commitments, notes Robert Beebe, president of Fundmerica.
Consequently, a proactive approach to clearing your debt will lead to a higher credit score. Your credit rating also takes into account your credit utilization, which compares the amount of credit used to your remaining available credit. Therefore, if an individual has a record of maxing out their credit card, their chances of securing a bank loan may be diminished, as they will not appear financially responsible.
Credit ratings range from 300 (very poor) to 850 (exceptional) and can improve or diminish over time based on a client’s financial behavior. While every bank has its own minimum requirement, a rating of 700 or more indicates a good chance of being approved for a business loan. Dissimilarly, alternative lenders have been known to offer loans based on a minimum credit score of 500 (very poor). The reason being, alternative lenders justify loans based on the overall health of the business and consider cash flow a good indicator of whether the company can repay its debts. As a result, according to Fundmerica, individuals and companies with poor or little credit history can still achieve a loan through alternative lenders despite being rejected by traditional banks.
As previously stated, banks like to minimize their risk by limiting loans to reliable borrowers, determined in part by their good credit score. Banks being highly selective in whom they approve for loans means that they approve fewer, safer clients than alternative lenders, which allows for lower interest rates. In contrast, FinTechs are focused on helping small businesses thrive and are willing to take on riskier clients with poor or little credit history. However, to make up for the added risk, alternative lenders offer loans at a higher interest rate. For example, banks offer an APR around 3-6%, while alternative lenders typically offer rates in the double-digits.
A red flag that often goes unnoticed by borrowers is how the interest rate is stated on a firm’s website. The rate should be expressed as an annual percentage rate (APR), which represents the actual yearly cost of funds over the term of the loan. The APR can vary significantly from the rate advertised online, as it usually does not account for origination and administration fees. Thus, to the client’s despair, the APR tends to be much higher than the rate clients believe they are receiving. “If borrowers are not careful,” cautions Robert Beebe of Fundmerica, “they could end up overspending on outrageous interest rates as opposed to using that money towards their business.” However, there are many FinTech companies that promote transparency by offering a no-obligation application for clients to check what they qualify for at zero cost. For instance, FundMerica’s website states that they offer APRs starting at 5.49%, which is very affordable for an alternative lending organization.
An important factor to consider when deciding between a bank loan and an alternative lender is how quickly you require the funds. Applying for a bank loan can be a lengthy process that begins with preparing a detailed business proposal to present to the loan officer. You will also need to compile several documents to be submitted for review, including your bank statements for the past 12 months, personal and business income tax returns, and business financial statements. For secured loans, banks will need to evaluate the collateral offered, which can further delay the process. As a result, it may take weeks or months before you get approved and even longer to receive the funds. Nevertheless, the approval process for alternative lenders is faster and involves less paperwork, notes Fundmerica. At a minimum, FinTechs may require completion of their online application and bank statements for the past three months. The approval process occurs completely online and clients can generally expect a response within 24 hours. If you have a short deadline for when you must receive the funds, an alternative lender can provide you with fast cash.
Recall that banks only approve “safe” clients with acceptable payment histories. To further protect their interests, banks commonly participate in secured lending. Secured lending occurs when a borrower pledges collateral to the bank for the term of the loan. If the client is unable to make their loan payments, the bank will seize and sell the assets to recoup their losses. The amount of collateral required on each loan will vary depending on the client’s credit rating, type of loan, and the nature of the collateral. Banks use the loan-to-value ratio to determine the amount of money a client is approved to borrow, such as 80% of the assets appraised value. Various forms of collateral include real estate, equipment, automobiles, and paper assets like bonds. In some cases, business owners may need to pledge their personal and business assets to be approved for a loan. Meanwhile, alternative lenders are more flexible when it comes to loan criteria. Most FinTechs do not require borrowers to pledge collateral, and instead, evaluate the financial position of the company.
Most banking institutions require a company to be in business for at least two years before they can qualify for a loan. Banks are interested in firms that possess a proven track record or at least have evidence of meaningful revenue. In general, banks are wary of supporting brand new businesses due to the poor survival rate of start-ups. According to the Bureau of Labor Statistics, 20% of small businesses fail in their first year and 50% of small businesses fail in their fifth year. While businesses fail for many reasons, some of the most common issues are lack of demand, poor management, and cash flow problems. Alternative lenders are not as rigid as banks, with some offering loans to businesses as young as six months old.
The Bottom Line, According to Fundmerica
Ultimately, the lender you choose to pursue will depend on your credit score, how quickly you need funding, the age of your business, and whether you qualify for secured or unsecured lending. Local banks are more likely to provide established businesses with financial assistance due to their longer banking histories and personal relationships with the client. Meanwhile, notes Fundmerica, start-ups with a faster need for cash might benefit from the streamlined lending practices offered by alternative lenders.