Be Careful When Borrowing From Alternative lenders

Gary O. Shelton

08/06/2017

Small business owners often use Merchant cash Advance to solve short term cash flow
problems. They shouldnt because it is a death trap.

Generally, alternative business loans are really expensive because of a business loan’s
cost structure. We can roughly break the costs down into the following 4 parts:

  • Lenders’ borrowing cost: Investors who invest in alternative business loans demand
    annualized net returns in the 10-12% range since these loans are perceived to be
    more risky, since they are usually under-collateralized and haven’t had a long track
    record to price their risk accurately.
  • Provisioned Loan Loss: Lender’s estimate their principal loss based on historical data.
    The estimated loss can be anywhere between 1-10% depending on the risk they are
    taking.
  • Borrower Acquisition Cost: Lenders need to spend on marketing to acquire a
    borrower. For example, they pay loan brokers 1-13% to acquire a customer. Check
    out this page and this article to get a sense of how much a loan broker can make.
  • Lender’s Expenses and Profits: Finally, lenders need to take a cut to cover their
    operational expenses and make a profit. This can be anywhere between 1-5%
    depending on the volume of loans they underwrite.

Let’s take an example of a $50K 6-month business loan and analyze its cost. Let’s also
assume that this lender doesn’t make any money.

                                         %age                                                                                              Cost
Borrowing Cost                      Based on a 6-month 11% loan                                    $1616.36
Provisioned Loss          5%                                                                                             $2500.00
Borrower Acquisition  5%                                                                                             $2500.00
Lender Keeps                0%                                                                                             $0
Total                                –                                                                                                 $6,616.36

As you can see, before the lender makes any money, it has already spent $6,616.36,
13% of the $50K borrowed, or an equivalent of 43.75% APR!!! If the lender is set to
make 3% of the principal amount, the APR becomes 62.32%, which is inline with the
APR we observed from the short term loan lenders. They are very expensive not
because the lenders make a lot of money but because the cost structure is really
broken.

So how do business owners get a more reasonable loan offer? I think there are 3 key
aspects to a cheaper business loan:

  • Longer repayment period: Instead of a 6-month loan, make it 3 years. This way
    the customer acquisition cost can be amortized for a longer period of time.
  • Lower borrower acquisition cost: the savings can be passed to borrower
    directly.
  • Individualized risk pricing: This is a very involved point. Instead of paying the
    investors 10-12% from a pool of loans with varying credit quality, make it a
    marketplace. Investors with low risk tolerance get a lower net yield with
    extremely high quality borrowers, while investors with high risk tolerance get a
    higher net yield with more risky borrowers. Let the investors pick and choose the
    loans they want to invest and lenders will pass the risk to them.

Fortunately, a Community Development Financial Institution (CDFI) is doing exactly
what is mentioned above.

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