The proliferation of entrants into the online lending marketplace has continued unabated since the financial crisis ended. With so many lending options to choose from, it’s important to remember that the online alternative lending marketplace has only been around for a few years. In 2014, Karen Mills and Brayden McCarthy published a study on the recent rise of marketplace lending in an effort to give the industry some benchmarks. Now, two years later, they have updated their study to provide more insights into just how much this industry has grown.
In their updated study (found here) Mills and McCarthy said, “By 2020, Morgan Stanley forecasts online lenders reaching $47 billion, or 16 percent of total U.S. small and medium enterprise (SME) approvals.” That’s a significant increase over where we currently stand.
We will be parsing the new report over the next several months, but here we want to point out a few key issues specific to the role of business loan brokers. As a broker, Original Funding seeks to connect small business borrowers in the U.S. with marketplace lenders as efficiently and cost effectively as possible. It’s an important role, and one we take seriously because the growth in the alternative lending industry has also allowed several bad actors into the space, creating confusion for borrowers who are often bombarded with unwanted solicitations.
Finding the right lender can be time consuming and expensive. According to the report, “Search costs in small business lending are high, for both borrowers and lenders. It is difficult for qualified borrowers to find willing lenders, and vice versa. Federal Reserve research finds that it takes small business borrowers an average of 24 hours to research and apply for bank loans and that they often approach multiple banks during the application process.”
That’s a great deal of time when you consider, as Mills and McCarthy said, that “over 70 percent of small businesses are looking for loans of under $250,000. And more than 60 percent want loans of under $100,000. Unfortunately, banks have more and more often turned their efforts toward the more profitable, larger loan segments, and moved away from small dollar lending.”
It’s precisely the disconnect between borrowers' needs and the lack of profitability in originating these kind of loans at traditional banks that has allowed for the growth in the online lending community. But the increase has come at a cost for thousands of small business owners who wind up applying to multiple providers and making uninformed decisions because they were being pushed too hard into a loan product that ultimately does their business a disservice and could even wind up destroying their personal credit rating.
As the report goes on to say, “Indeed, the process of obtaining a small business loan is complex at best, and bewildering at worst. Consider the elements of the process: the time and energy required to navigate the labyrinth of lenders; differentiating between at least 12 different types of credit product, each with varying use cases; filling out three-inch thick loan applications; compiling and submitting supporting documentation, such as bank statements and tax returns, most of which is done manually; and making sense of how loan offers stack up on features like price and terms. The process is often so complex that a survey conducted by the Federal Reserve Bank in 2013 found that borrowers spent an average of 22 to 34 hours for profitable and unprofitable loans, respectively, and 26 hours for all firms on average.”
And yet because traditional banks have little incentive to dive back into the small business lending arena to the extent they were involved pre-financial crisis, borrowers are continuing to navigate the often unfriendly waters of marketplace lending. According to the 2015 Bank of America Small Business owner survey, which the report cites, "35 percent of small business owners said they planned to apply for credit in the next 12 months, up from 24 percent in 2014, and 21 percent in 2013.”
The good news is that most of the borrowers are seeking capitalization either to start a business or bring on working capital to expand an existing business. For the economic recovery to fully take hold in our country, we all need small businesses to find access to lower cost capital and grow. Since SME’s make up the majority of the workforce, it’s imperative for consumer spending, wage growth and employment figures, all of which are key drivers of economic stability.
A word of caution repeated throughout the report, however, is that the new marketplace lenders—especially the ones that have achieved great success—have never been tested by a downturn in the economy. As a nation, we’ve been trending positively in terms of personal and business credit because so many people took their lumps during the financial crisis, wound up de-leveraging and building back their credit profiles. As a result, marketplace lenders have had a wide and forgiving environment in which to build their models. Even still, several of the most well-known players in the industry, such as Can Capital, have still struggled. If highly capitalized, early market entrants have found it difficult to find their footing in a relatively positive economic climate, it could spell disaster should things go south.
Add to the mix the bad actors who've entered this space and there is even greater risk for upheaval. Because alternative online lending is still fairly unregulated, something the report goes into in great detail, it has invited less-than-reputable business loan brokers and predatory lenders into the market. Seeing this trend unfold before our eyes was the primary reason we formed Original Funding. Because we were backed by a marketing and technology firm, we were able to enter the market quickly with a digital platform to offer broker services to borrowers. Beyond that, our strategy to beat out less reputable firms is to simply offer our services at a rate that is literally half the industry standard. On top of this, we don’t charge for applications or take fees directly from borrowers. We’re paid a commission by the lender of 6 percent, which—like we said—is HALF the industry standard before adjusting for fees.
In addition, we actually take the time to listen to our borrowers and find the right loasn for them. More often than not, we’re actually talking borrowers out of pursuing some marketplace loans because they won’t qualify for the ones that will actually help them. Some unscrupulous brokers will try not only to push a hefty loan on a borrower but they will also try to get the loans from more than one lender at the same time, thereby taking multiple commissions and fees. This is what is known as “stacking,” and it’s one of the worst practices in the industry.
That’s why we caution every applicant who comes to us, whether we work with them or not, to apply just once with Original Funding and let us evaluate their profile. Time and again, we’ve seen borrowers unwittingly commit fraud because their loan brokers are pushing them into unsavory situations that wind up hurting them. Again, from Mills and McCarthy's Harvard study: “According to research from credit-reporting firm TransUnion, on an average day, about 4.5 percent of people who take an unsecured personal loan go back for seconds at other lenders that day. Loan-stacking activity more than doubled from 2014 to 2015...Borrowers who take out a second loan within 15 days are four times as likely to be later identified as fraudsters. A third loan makes borrowers 10 times as likely to be frauds.”
Until the industry is regulated, and the best practices and standards have been adopted, it’s important for borrowers to arm themselves with as much knowledge as they can get during the application process. Just because traditional banks have turned their backs on Main Street America doesn’t mean that the new lenders are the best source of funds.
The good news is that we believe 2017 will be a borrower’s market. We’ve even added new partners for our products such as commercial real estate hard money lending to expand our service offerings. We’ll continue to report on new trends and dive deeper into this particular study, which is the most comprehensive analysis to date on marketplace lending. For now, here are a few important takeaways for our borrowers: