Beware of the Fine Print - What to Watch for with Online Small Business Lenders
In recent posts, we have explored the massive consolidation of the community banking industry and examined how that consolidation is making it harder for small businesses to access traditional bank loans.
This post will look at how some of the new and emerging online lenders are offering suboptimal products to fill the void left by banks. Many of these products are ill-suited for growing Main Street businesses and worse, as Bloomberg reported in a stunning exposé, some online small business lenders are outright predatory.
Many new lenders offer fast funds, but at a hefty cost. As small business owners thinking about working with online lenders, we urge you to read the fine print, consult trusted advisors, and know what you are getting into. Below are a few key items that you should look out for while exploring your funding options.
1. High Interest Rates
First and foremost, it is worth noting that many online small business lenders charge very high interest rates. For example, both Kabbage and OnDeck, two of the largest online small business lenders, advertise APRs of up to 99% and a report by the Opportunity Fund found that online small business loans average a whopping 94% APR!
Some online lenders are not transparent about their pricing and can make it hard to find your interest rate. Be sure to figure out what you are actually paying when you take on debt!
2. Variable Interest Rates
A variable rate loan is a loan where the interest rate adjusts along with some sort of macroeconomic indicator, usually the “Prime” interest rate. Lenders often push businesses to accept variable rate loans.
While variable rates can initially be slightly less expensive than fixed-rate loans, they give business owners far less stability and make it difficult to know what your payments will be a few months, much less a few years, down the road. Before signing up for a variable rate loan make sure you understand how and when your payment may change, and what these changes are tied to. Understanding how your interest rate may change is especially important in our current rising interest rate environment.
3. Revenue Sharing
In lieu of interest rates, some online small business lenders encourage businesses to accept revenue sharing agreements. Revenue sharing can be a good model if you are confident in your financial projections and your profit margins across product offerings.
However, revenue sharing can be very expensive, with lenders taking 1-8% of your top-line revenue until your repayment cap is reached. Repayment caps vary widely but can be as high as 3x the amount of money you initially borrowed.
Nearly all lenders charge some fees to cover their expenses to underwrite, issue, and manage your loan. These fees can take many different shapes and sizes ranging from application fees, underwriting fees, origination fees, management or services fees, referral fees, legal fees, filing fees, and many, many more.
Sometimes fees are a percentage of the total loan size which helps keep costs down for smaller loans but can be very expensive for larger loans. Other times fees are quoted as a fixed fee which has the opposite effect - disproportionately increasing the cost of borrowing for a small loan. It is also worth noting that sometimes fees are cashless (taken out of the money you are borrowing) and other times you will need to pay the lender upfront.
Pay attention to all of the fees associated with your loan and make sure you are accounting for them appropriately when exploring your total cost of borrowing. Remember, the cost of your loan isn’t just your interest rate, it is also fees!
5. Prepayment Penalties
Nearly all online small business lenders include prepayment penalties in their terms. This means that, even if you have the money to pay your loan back early, it will cost you extra to make those early payments. This can also make it difficult and prohibitively expensive to refinance a loan in the future.
Some may consider Prepayment Penalties, just another fee, but it is important to understand how this may impact you months or even years down the road.
6. Confession of Judgement
A confession of judgement is an agreement to waive a business’s right to dispute a claim from a lender. If for example you were to trigger a debt covenant and you had a confession of judgement in place, the bank would have the right to skip legal proceedings and move immediately to collections.
Confessions of judgement are used by most lenders, including many reputable players. While the vast majority of lenders use confessions of judgement responsibly, several predatory lenders have used them in far more aggressive ways. These predatory lenders will trigger collections processes at the first sign of any distress in the business. This knee jerk reaction can take businesses by surprise and turn a small hiccup into a catastrophic event as the lender begins collections proceedings and triggers other lenders to do the same.
If you are agreeing to a confession of judgement, be sure to understand what could trigger its activation.
7. Daily Payments
Some online lenders, like Square Capital, are directly integrated with your credit card payment processing and will take your loan payment directly out of credit card transactions. Others like Everest, will pull money out of your bank account every business day.
Lenders do this to make sure that their debt obligations are satisfied first. But, this can be crippling for cash flow as online lenders are constantly reaching their hands into your piggy bank (or snatching the quarters before you can even put them in). Be sure you understand how and when your loan payment will be paid and the implications those payments will have on your cash flow.
Keep in mind that regulations around small business lending are few and far between, so it can sometimes be difficult to find some of this information listed above. Be sure to do your homework, ask questions, and speak with an accountant, lawyer, or other small business owners before taking the leap.
Have you worked with online small business lenders? How was your experience? We want to hear from you! Tell us your story by emailing us at email@example.com or commenting below.
About Honeycomb Credit
Honeycomb Credit is a crowdfunding platform that allows locally owned small businesses to borrow loans directly from their own loyal customers and fans.
All money raised on Honeycomb is paid back as a fully amortizing loan at fair interest rates. Honeycomb does not charge prepayment penalties, require a confession of judgment, or blindside you with hidden fees. Click here to learn more about the process or our pricing.