In the wake of the Great Recession, small businesses found it difficult to secure loans via banks – and even when they were available, the common complaint was that the application process was slow, time-consuming, paper-intensive and ill-suited to the needs of small businesses.
From that gap sprung forth a group of alternatives for underwriting access, which varied widely in terms of structure, funding sources and target demographics. As diverse as they may be, they share a few common characteristics: an automated online application process, the use of proprietary algorithms to determine creditworthiness and a focus on speed and inclusivity.
On that score, online lenders have been successful, according to a just-released study from the Federal Reserve Board. According to the Fed’s annual Small Business Credit Survey (SBCS), credit seekers are increasingly turning to online lenders – particularly smaller, newer and minority-owned firms. The SBCS also notes that online lenders are far more likely to fund medium and high-risk credit applications than their bank counterparts, with approval rates of 76 percent versus 34 percent at large banks and 47 percent at small banks.
As for what is attracting borrowers to non-bank digital lenders, odds of approval are unsurprisingly important, as the best lenders tend to be the ones that actually give out funds – at least from an SMB’s point of view. But speed was just as critical a factor.
That, according to the Fed, is the good news. The more troubling statistics are around customer satisfaction: SMBs find online lenders easy to work with upfront, but they don’t necessarily love what they get from them across the board.
“While more applicants are successfully funded at online lenders, the SBCS indicates satisfaction levels with online lenders are far lower than with traditional lenders (net satisfaction of 33 percent at online lenders versus 73 percent at small banks and 55 percent at large banks),” the Fed noted in their report. “In 2018, 63 percent of online lender applicants reported challenges working with their lenders, with more than half saying they experienced high interest rates, and almost a third reporting concerns with unfavorable repayment terms.”
So what is going wrong between the easy application process and actually living with the loan? According to the Fed, that is actually a more complicated question than it might seem on the surface, because the digital lending landscape for SMBs is rather more diverse than for its counterparts in the consumer and enterprise lending space. While it is common to colloquially lump all SMB underwriting operations under a single umbrella of “digital lender,” the study notes, those lenders are very different from each other when one digs into the specifics of their set-up.
And those specifics, the reports noted, are quite significant. The biggest divide, the Fed notes, is between loans and credit products versus merchant cash advance products. The former generally features fixed rates, multi-year terms, fixed monthly payments and APRs ranging from 10 percent to 80 percent. The latter entails the sale of future receivables for a set dollar amount, repaid with a fixed percentage of the business’ daily sales receipts – and they have terms that vary greatly, though they are generally much shorter, in the three- to 18-month range. APR equivalents there run much higher, from 80 percent into the triple digits.
And within those major categories, actual specifics range more widely, the Fed notes, based on other features and functions of how a specific online underwriter is structured.
The first difficulty is that the merchant borrowers themselves often aren’t aware of the degree of nuanced differences that can exist within the online lending arena, tending to group all of these widely different things under a single heading.
“Though some online lenders specialize in specific types of financial products, it is clear from Federal Reserve focus group studies that small business owners view these companies collectively as lenders, and their various products as loans,” the report wrote.
The second, and more challenging, difficulty is that simply admonishing borrowers to better do their homework when seeking out underwriting options is potentially unhelpful – the data they need to make apples-to-apples comparisons is not always easily available. Unlike the realm of consumer loans, where the Truth in Lending Act requires underwriters to clearly disclose product costs and features, business lending operates outside the scope of the TIL. That means lenders have a good deal more flexibility in how they disclose their costs and loan structures, down to what language and terms they use to describe them.
And that means even an SMB owner who wants to research and understand exactly what they are agreeing to may find that complicated.
“Qualitative studies suggest that small business owners struggle to understand the wide range of products offered by online lenders, and the unfamiliar terminology that some lenders use in their product descriptions,” the Fed’s report notes.
Areas of particular concern were lack of borrower clarity about the full cost of loans, lack of understanding about the length of the loan and confusion about how the data offered up during the pre-application process is collected, stored and possibly used.
As for solutions, the Federal Reserve noted that efforts around standardization in data reporting among SMB online lenders is being pursued, both legislatively in California and via cooperation for various industry participants and groups looking to create a standard before one is imposed on them by lawmakers. Those efforts, however, are complicated by arguments over where the standard should be set when it comes to reporting information on loans and costs.
For example, the report noted, while some have argued that the historical APR metric is the clearest and most understandable measure for consumers, some have argued that it should not be applied to small business products with variable payments and no fixed term, such as MCAs, because the structure of the product is entirely different than what was intended to be measured with APR.
Plus, the Fed notes, that standardization of cost reporting may not quite be a silver bullet, because of the diversity of factors that goes into choosing a loan among business owners.
Research suggests that borrowing decisions are not always driven by costs. For example, while among the focus group participants, “best price” was the most commonly mentioned top factor in their choice of lender, “quick and easy loan application process,” “a lender I know and trust” and “likelihood application will be approved” were primary considerations for others.
But, the survey noted, while consumers can make choices on a variety of factors, they need to be able to clearly evaluate them going in. Cost may not be the driving factor in the decision of loan product, for instance, but all borrowers need to know what the costs will be. And until industry satisfaction levels with the products come close to satisfaction levels for the onboarding process, the Fed’s data seems to strongly imply that there is still a lot of work to do in terms of presenting lending products to SMBs.