Be Careful When Borrowing From Alternative lenders
Gary O. Shelton
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
- 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.
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
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
- 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.