Understanding the Risks and Rewards of Peer-to-Peer Lending

By Trevor Dryer

If you run a small business, you probably know all too well the challenges of trying to get a loan. It can take days to research options and fill out inches-thick paper applications, only to wait weeks, and even months, to find out you were turned down. All the while cash flow is tight, and you’re struggling to hire new employees, manage inventory, buy new equipment, or open a new location.

As you may have experienced, getting a business loan has gotten more problematic during the last several years. The economic downturn in 2008 created significant obstacles for banks and other traditional “Main Street” financial institutions that traditionally lend to small businesses.

State of Small Business Lending

For example, many banks are increasing their capital reserves to comply with new standards initiated by bank examiners and other regulators, which can undermine a banks' ability to underwrite small business loans. In addition, compared to large businesses, small businesses are riskier lending propositions because they are more sensitive to swings in the economy, have higher failure rates, and fewer assets to use as collateral.

Small business loans also are not as profitable for banks, because they cost the same amount to originate as larger loans. For this reason, banks tend to put less emphasis on lending in the sub-$500,000 range. This creates a large lending gap for small businesses, which tend to seek out significantly smaller loans; 70 percent of small businesses seek loans of less than $250,000, with more than half of those needing loans of $50,000 or less, according to the Federal Reserve’s “Small Business Credit Survey.”

Realizing an opportunity to reach an underserved market and building on the trend of crowdfunding, new types of small business lenders have emerged. Funded by Wall Street investors, these online and peer-to-peer lenders–such as OnDeck and Lending Club–are leveraging technology and user-friendly Web-based application processes to quickly respond to loan requests from small businesses. By reducing the origination costs, these processes make it more profitable to lend smaller amounts.

Rewards of Peer-to-Peer Lending

Online lenders are exploding in popularity, thanks to their customer-friendly practices and ability to give small businesses fast access to much-needed capital. Industry experts estimate that since 2007 online lenders have originated an estimated $10 billion worth of small business loans, with the majority of the lending taking place in the last few years.

Despite the buzz around online lenders, they still only account for less than 1 percent of total small business loan volume. In comparison, new small business loans originated by banks alone account for roughly $200 billion annually, according to the FDIC.

While traditional lenders still originate the lion’s share of small business loans, there are certainly times when working with online lenders may make sense for your business. For example, if your business needs cash right away or requires flexible payment terms, such as paying a percentage of your credit card receivables instead of a fixed monthly payment.

If you’ve just started a business, getting a loan from an online lender also may be an option to help you start establishing a credit history. Or, if your business has a less-than-stellar credit or financial situation, it could help you repair your rating to help you qualify for a loan from a traditional lender in the future.

Risks of Peer-to-Peer Lending

As with any decision related to your business, when seeking loans from online lenders, it is important to weigh the risks versus the rewards. Behind the slick user interface, excellent marketing tactics, and fast approval turnaround, there are some potential pitfalls that could negatively impact the bottom line for many small businesses.

It’s important to consider several factors when choosing an online or peer-to-peer lender to ensure you don’t get caught off-guard by unpleasant surprises, such as:

● Restrictive or shorter repayment periods. Some online lenders require payment in just six months, which is considerably shorter than the three year intermediate-term loans that banks offer. This would result in monthly payments higher than if you had a longer repayment period.

● Exorbitant interest rates. Many small businesses are used to comparing the cost of loans by using the annual percentage rate (APR), which is the periodic interest rate multiplied by the number of compounding periods in a year, and includes certain non-interest charges and fees. But doing the same when deciding whether to use online lenders becomes problematic because repayment periods are often less than a year, there may be terms that require larger payments in the first few months of the loan, or there are hidden fees not incorporated into the advertised interest rate.

Some online lenders may not even technically be offering loans per se. If you look closely at their contracts, their offers may be structured like a cash advance, which is similar to the tactics used by payday lenders to avoid having to comply with lending regulations. By accepting a “cash advance” instead of a loan, your rights could be greatly limited when compared to a traditional bank loan that offers protections through federal and state lending laws. Because of these variations, you often end up paying significantly more for a loan from an online lender.

A comparison of online lenders by Fit Small Business estimates that average APRs range from 40 percent to 80 percent. Once the various fees are factored in, borrowing from other online lenders could potentially result in estimated APRs as high as 300 percent. Banks and credit unions, on the other hand, typically offer an APR of 6 percent to 8 percent.

● Surprise fees. While banks often include their in the calculation of APR, online lenders can have a number of fees of which you may not initially be aware. You will want to check the fine print closely to understand the types of fees for which you’ll be responsible, including those for origination, daily loan guaranty, and prepayment.

● Lack of a personal relationship. Banks typically forge long-term, personal relationships with their account holders and understand the nuances of the small businesses and the local markets they serve. If you primarily use one bank for all of your accounts, this relationship can translate into lower fees and ancillary perks, such as higher rates on savings accounts or waived annual fees on accounts or credit cards.

These long-term, personal relationships can become more valuable as your business grows, because your bank can provide new financial products or structure financing differently to correspond with your company’s stage of growth. Many banks indicate they would prefer to loan to their existing clients, but cannot if these small business customers don’t meet their lending criteria.

Online lenders do not have the ability to develop these types of personal, face-to-face relationships with small businesses.

● Who is funding your loan? The source of funding for loans also can play a role. Banks rely on FDIC-insured deposits, which helps keep the cost of capital low. Online lenders have high-cost capital from institutional investors and other sources that are looking for high yields, and this capital is at considerable risk if Wall Street loses interest in funding this type of business model or decides to move their capital elsewhere.

New Standard for Borrowers

Online lenders have truly set a new standard for borrowers. They’re improving the user experience with simplified online loan applications and, in some cases, almost instantaneous lending decisions. They’re also expanding into a diverse range of loan options for general consumers, students, and small businesses.

Banks and credit unions are quickly learning from the competitive pressure and success of online lenders. Some of the most forward-thinking lenders are now adopting technologies that will mirror the online lending experience and offer the low interest rates that only banks and credit unions can provide.

These technologies enable loan officers to make faster decisions while reducing origination costs for even small dollar loans, which in turn will increase the number of small business loans banks and credit unions can make and meet the needs of businesses that are seeking smaller loans.