Small Business Loans From New Online Lenders Are Very Costly

In an improving economy, an entrepreneur's fancy turns to expansion—and how to fund it. Trouble is, getting a bank loan is a lot tougher nowadays, and new web-based lenders often charge much higher rates.

The Great Recession changed the rules. Seven years after it ended, many banks, leery about the greater risks that small businesses pose, are unwilling to lend to them. Traditional banks have reduced small-business loans by 20% since the financial crisis, according to a 2014 Harvard Business School study.

Filling the vacuum is a new cohort of lenders—many of them online—offering financing for small businesses. Armed with sophisticated algorithms, providers such as OnDeck Capital, Kabbage, and Fundera can disburse money in a matter of days or even hours, rather than weeks or months.

These new lenders range widely on the credit spectrum. Some make loans that compete with banks, but most essentially offer variations of the merchant cash advance: short-term, repaid with credit cards or cash generated from the business.

And the new abundance of short-term capital in particular poses new hazards for borrowers. For one thing, these lenders tend to price their loans in a way that makes it difficult to compare them to traditional term loans.

Moreover, many of them happily seek out riskier borrowers. Why? Because they charge so much more for the loan than traditional lenders and are willing to absorb high default rates. They may not care whether the monthly payment breaks any one business. Enough keep paying to sustain them. So before shopping for a loan, it's more important than ever to understand how much you're paying—and whether you can afford it.

Know the relative price of money. Short-term lenders often quote rates that at first blush are on a par with a credit card interest rate, if not a bank loan. But the comparison, whether intended to be so or not, is misleading. Usually the rate is much higher.

The difference stems from the way the cost is computed. Banks use an annual interest rate, where the interest is assessed periodically on the outstanding principal balance. On a bank term loan, that balance is always declining: The borrower pays interest on the full principal amount only in the first month, and also retires part of the principal with each payment. In the last month of the loan, the borrower pays interest on only a small portion of the loan that remains.

As a result, the actual annual interest rate on the total amount borrowed is far lower than the stated rate. For example, on a one-year loan for $100,000 at 15% annually, you would pay $8,310, not $15,000. (The interest rate is then bundled with other fees to create a comparable annual percentage rate.)

But that’s not the way the new online lenders work. While federal law requires consumer lenders to present loans in terms of annual interest rates, small-business lenders have no such obligation. Instead, merchant cash advance and other short-term lenders prefer to quote rates as a percentage of the total principal amount and describe that as a fee, a factor, or what one lender, OnDeck Capital, calls a "cents on the dollar" rate.

Consider a one-year loan for $100,000 with a 15% fee. The online lender may start electronically withdrawing payments from a small business’s account weekly, which lowers the borrower’s capital but still leaves you paying that mid-teens rate on the smaller amount. Add in fees from the lender and that $15,000 charge is equivalent to paying a 27% annual rate. If it were a six-month loan instead, the equivalent annual rate would be nearly 50%.

OnDeck, for its part, argues that businesses are more interested in the absolute cost of a loan than its annualized interest rate, which can make short-term loans seem more expensive than a longer-term loan, even though the short-term ones may carry a lower total cost. It also notes that its interest rate has declined in each of the last 11 quarters.

Know what you can afford. Banks often use complicated ratios as part of their underwriting, but for the borrower, it all comes down to whether you have enough cash coming in to make the monthly payment. Business advisers recommend doing a three-year cash-flow projection, monthly for the first year to capture seasonal variations, and quarterly for the following two years, to see if the loan is affordable.

To create the projection, start with how much money you anticipate having in your checking account at the beginning of the first month. Add to that all the cash from sales you expect to come in during the month, then subtract all your expenses. Then subtract your proposed loan payment.

The ending balance for the month becomes the opening balance for the next month, and the calculation repeats for the full year. If the ending balances are always positive, then the loan is affordable—with caveats, of course.

The first caveat is that you can't really trust your own assumptions. Revenue may not be as robust as you expect. Expenses may be higher.

Some small business advisers recommend benchmarking your own projections against industry statistics. These numbers are usually available at Small Business Development Centers–partnerships between the U.S. Small Business Administration and local colleges or universities, designed to aid entrepreneurs–or through public libraries.

Prudent pessimism is a watchword when making business projections. Bruce Morse, a counselor at the Small Business Development Center network in Wyoming, recommends making a second estimate with higher expenses and lower revenues, reduced by 20% or 25%. "If it still works, great," he says.

The second caveat: You need to factor in a cash reserve, needed to support the business in lean times. How lean? Try zero revenue for a three-month span. How much of a cushion you'll want depends on the type of business and your own risk tolerance.

Walter Manninen, an adviser with the Massachusetts S.B.D.C. network, suggests 20% of revenues as a good rule of thumb. Seasonal businesses in particular will want to keep a reserve to fund operations, including a loan payment, in the low-sales months.

Morse notes that some businesses use a line of credit, from an online lender or a bank (assuming one is available to them), to fund those down-cycle expenses. Similar to a credit card, you must repay an LOC on time or risk higher interest rates. This move obviously adds to your debt load.

Tailor the loan term to what you're financing. Assets with a long life, like real estate or equipment, should be financed with a longer-term loan. Such a loan will have a smaller monthly payment (although ultimately it will cost more because you are paying it off over a long stretch of years).

Use a shorter-term loan for short-term assets, like inventory. "You do not want to still be paying for a short-term need after the asset has been sold, used, or had to be replaced," says Morse. And "if you need to stretch those payments in order to make it work in your cash flow, then it probably isn’t affordable in the first place."

Running a small business is difficult enough. Make sure not to get blindsided when figuring out how to finance it.