Alternative vs Traditional Business Lender: Pros & Cons
With countless small and medium business enterprises seeing the light of day in recent times, each happens to have its unique identity. But the one thing that’s common to all of them is a perpetual requirement for capital. This is because every businesses needs funds to grow, especially the smaller ones which have just about got up to get running. Thus, borrowing money becomes imperative as the only catalyst for growth.
Earlier on, traditional banks and/or credit unions were the sole options for taking small business loans. However, as the Internet grew, alternative lending is gradually becoming the order of the day also.
Two main differences between a traditional and an alternative lender are: Who they lend funds to, based on certain risk factors; and how they shall get such money back from their debtors. The following are the major differences between alternative and traditional business lenders as also their individual pros and cons:
Conventional banks prefer to avoid risk at any cost. They take their loaning decisions on the prospective debtor’s payment history, credit score, history of cash flow and projected future earnings. Moreover, they are always comfortable when a debtor has enough collateral to pledge against any fund that he borrows. However, for a new business, this could be a major stumbling block, especially when a loan is desperately required to survive, expand and earn its revenue.
On the flip side, an alternative lender assumes the bulk of the risk involved. They welcome businesses having a poor or even non-existent credit, with additional options for those riddled with a bad credit score. This makes it easier for the latter to readily obtain cash. An alternative lender is also capable of circumnavigating around issues like bankruptcy, negative balances, tax liens and smaller deposit frequencies with greater ease, which a traditional bank won’t usually accept within its underwriting guidelines.
The Pros and Cons
Banks are usually more difficult to work and negotiate with. However, the advantage is that a bank will allow a debtor to stretch his payments with longer repayment terms at lower rates of interest. An alternative lender on the other hand, isn’t as picky about the character of the debtor who’s about to receive its funds despite his poor financial condition. However, he will insist on faster repayments at higher interest rates.
Conventional banks take a much longer time period to approve a loan because they only disburse a loan after numerous back-and-forth discussions on eligibility and terms. This may take anything between four to twelve weeks before the funds hit the debtor’s bank account.
Alternative lenders score in this regard as they are known for their quicker turnaround time. They give approvals in hours and make ACH transfers to their borrowers within 24 to 48 hours. This comes as a boon to new businesses needing startup capital fast. However, it is always prudent to do study the lender carefully because even though a faster turnaround is always welcome, it’s ultimately the lender’s honesty and credibility that matter and this requires due diligence.
A traditional bank generally provides you terms under the APR or Annual Percentage Rate structure. This is approximately the borrowing cost under a pre-set consideration that the borrowing would be made over a period of at least 12 months. In most cases, a traditional bank will spell out a term length that greatly exceed this 12-month period because this is where it makes the most of its money. Moreover, the remittance structure usually is monthly for loan repayment.
The alternative lender provides the borrower a factor rate, representing the borrowing cost which is shown as a fixed fee. For example, if a borrower gets an advance of $100,000 at a 1.2 factor rate, then the full amount that he needs to pay back at the expiry of his term length will be $120,000 and it would generally be fixed. However, certain incentives are also given to the borrower should he repay early.
This is missing in traditional banking circles, which charges a penalty actually for pre-payment! Moreover, an alternative lender’s remittance structure is usually daily or weekly and not usually monthly.
Traditional lenders offer lower rates of interest. They also grant more time for repayment. However, certain canny operators charge hidden costs and interest and which are not clearly communicated to a prospective borrower initially. Also any loan that locks the borrower for the full loan term length with no chances to repay earlier is best avoided. Borrowing costs from alternative lenders tend to be a trifle higher but since repayment is either daily or weekly, the confusion from the entire borrowing process is eliminated.
Underwriting & Origination Fees
Banks are directed by law to present their fee structure as a percentage of the origination amount. This implies that the higher the amount subject to approval, the higher will be their fees. This is more so as banks take lower interest than alternative sources, and tend to earn more through their fee structure. This nickel and diming procedure is all too common to banks.
Alternative lenders usually charge a straight processing or origination fee. For instance, on an advance of $200,000, the processing fee will be $500 while $650 would be charged as origination fee. These fees are chargeable on the full amount approved. To quote an example, if a sum of $100,000 gets approved with total fees amounting to $800, the borrower would receive $99,200 net in his account.
Although banks apparently give you a lower interest rate, they make a killing on the fee structure. Alternative lenders on the other hand, may charge higher factor rates and interest, but their fee structure is usually more palatable.
However, with both lenders, there are usually no extra costs because the fees are payable from the advanced amount. If a borrower ever feels that he is at a risk of default, it would be prudent to let the lender know in advance so that negotiations can be done to avoid additional fees payable.
Anne is a Senior Author for SBL. She began her career as an independent consultant for local businesses after graduating with a BA in Management. Since that time, she’s expanded to writing as well as consulting to spread helpful knowledge to small business owners across the country.