The 411 on Online Lenders

Online business loans are a quick and relatively easy way to get funds. However, there are often risks, too, including very high interest rates and unrealistic repayment schedules that can affect business financial health. A small business owner is left to wonder how to choose an online lender on top of all their other responsibilities.

First let’s examine the difference between an online lender and a traditional lender. Unlike traditional loans that involve meeting with a banker or other representative, online borrowing uses technology to drive lending. Decisions are quicker and there are usually more approvals, but because online lenders take on more risk, these loans often come with much higher interest rates and fees and shorter repayment terms.

Online loans for small businesses grew out of the 2008 financial crisis when banks cut back on small-business lending. Today, online lending makes up more than 20 percent of all small-business loan applications according to a 2015 small business credit survey prepared by Joint Federal Reserve Banks.

Who provides online loans?

Online loans are often made by “alternative” organizations such as responsible non-profits, like Excelsior Growth Fund (EGF), which are called community development financial institutions (CDFIs), and riskier groups such as peer-to-peer lenders, merchant-cash providers or marketplace lenders.

Why use online business loans?

Business owners use online lending if they don’t qualify for traditional bank loans, or they want the speed and ease of the online process. A typical online application can be completed in 30 minutes, approval rates are higher and funds can be received in as little as 3-5 days.

What are the risks?

The primary drawback of online borrowing is the high cost, measured by annual percentage rate (APR). The APR on merchant-cash advances usually starts at 50 percent and can go above 100 percent, and APRs for online term loans start at 15 percent and can go much higher. Often, too, they require weekly or even daily loan repayment. These terms can crush many small businesses.

How to choose an online lender:

1. Identify your need.

Before you do anything, know what you need. Is it short-term funding for inventory or to cover bills? If so, a loan with terms of 12-24 months may help with temporary cash shortfalls, although high interest rates and short repayment terms could be more harmful than helpful. If you need funding to purchase longer-term assets such as equipment, a loan with a term of three or more years is better, although most online lenders only offer terms of two years or less.

2. Screen online lenders.

Predatory practices are common with online lending. Look for lenders or brokers who offer loan terms up front, have a physical address, and display website security disclosures on web pages. If you’re considering an online loan, explore options available through responsible community lenders, such as CDFIs, first.

3. Conduct a true-cost comparison.

The only reliable way to compare loans is to compare APRs—which includes the total amount you’ll pay back with interest rates and fees—and repayment terms:

Merchant cash advances have the highest APRs and repayment is generally daily or weekly

Online term loans have higher APRs than traditional bank financing (but significantly lower rates than merchant cash advances) and repayment terms may vary from weekly to monthly

Another important feature is the ability to prepay without penalty.

4. Know what lenders focus on.

For competitively priced loans with lower rates and better terms, lenders emphasize debt service coverage ratio (DSCR) – a measure of the likelihood that your business’s cash flow will cover its debt. A strong personal credit score may make you attractive for a small-business loan, too, and consider whether your business has inventory or property that can be used as collateral (be careful about what you offer, though).

5. Ask about additional services.

Choose an online lender that offers additional services, such as free technical advice and help with longer-term financing and growth plans.

6. Know your rights

Finally, before choosing a lender make sure you read the Borrower’s Bill of Rights. The Borrower’s Bill of Rights was created by the Responsible Business Lending Coalition to encourage lenders to commit to fair-lending practices and to educate small-business borrowers. The trick is that committing to the Borrower’s Bill of Rights is optional for lenders and, since not all lenders do it, even seasoned small-business owners can fall prey to bad loans when financial difficulties arise.