In the U.K., the alternative small business lending market is booming. But research published earlier this year found that SMEs in the nation are a bit overwhelmed with all of the alt-finance choices out there.
Across the pond, the rise in alt-lending in the U.S. has been a bit less consistent. But according to a new Federal Reserve report, SMEs are just as flustered as their U.K. peers when it comes to narrowing down the copious amount of financial platforms to use when in need of working capital.
Analysis conducted by the Federal Reserve Board and the Federal Reserve Bank of Cleveland to assess small businesses’ processes when pursuing financing uncovered a bit of troubling news: SMEs are pretty confused when it comes to comparing their alternative lending choices.
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Last month, researchers at the Fed spoke with small businesses across a range of industries, each with fewer than 20 employees and less than $2 million in annual revenue. They are the “Mom & Pops” of the small business world, and the report said the Federal Reserve aimed to envision the process of accessing liquidity through the eyes of these business owners.
The report’s authors, Barbara J. Lipman and Ann Marie Wiersch, made a point to note that their paper is based on a relatively small sample size — just 44 small businesses — and thus can’t be used to draw conclusions about the alternative lending industry in general. “Rather,” the report said, “the intent was to surface key issues that could guide future research, data collection and policy analysis.”
And boy, did the authors surface issues.
The analysis found a slew of points that are likely to impact the development of the market. For example, the authors said small business owners hold a “negative to neutral” reaction to online alternative lending marketplaces, but that those impressions turn positive once a small business owner actually visits a lender’s site.
Small business owners also consistently mentioned data security as a key concern throughout the researchers’ study.
But one of the key findings of the report is that small businesses may be overly confident about their ability to choose the right alternative finance option.
“Although participants initially said it was ‘easy’ to evaluate credit products, when presented with several options, many expressed uncertainty or answered questions incorrectly when making specific product comparisons, particularly on cost,” the report concluded.
Part of these mistakes can be traced back to an inability to accurately identify interest rates. Specifically, it’s the various ways that each alt-lender structures its fees that generates uncertainty among borrowers.
“The lack of standardization in how online lenders present their products was problematic for many focus group participants,” researchers concluded.
Some lenders identify their interest rates as an APR, while others provide a total fee amount over a period of time, like six months or 12 weeks. Some companies highlight a fixed interest rate but don’t spell out loan origination fees in their quotes, the report added.
To put this confusion into numbers: The researchers presented one alternative lending product to study participants that saw a $40,000 loan and $52,000 ultimately due. Payment was charged based on 10 percent of a company’s total debit and credit card sales every day.
Businesses were asked to calculate what they thought the APR was on this loan offer. And while APR is impossible to pinpoint because it depends on daily sales volumes for the business, the researchers said, small business owners identified APR as anywhere from 4 percent to 50 percent.
According to Lipman and Wiersch, the lack of information about the effects of early repayment and other details can create incredible confusion among potential borrowers — and that confusion could ultimately cost them big bucks.
Certainly. the findings raise some concerning points about an industry that is still in development, the authors added. “While the industry holds promise for expanding access to credit, it also raises potential risks for small business borrowers, as these products can be considerably more expensive than traditional credit,” the Federal Reserve Bank of Cleveland said in announcing the research. The information in the report may not be a reliable source for conclusions of the nation’s alternative lending industry, but it could provide insight into the need of market transparency and small business education.