Just 10 years ago, the phrase “alternative lending” wouldn’t have meant too much to small business owners.
But now, alternative lending is an important part of the business financing industry. Without it, far fewer entrepreneurs would be able to secure the funds they need to start new companies, deal with emergencies, prepare for trouble, or expand their businesses.
Without alternative lending, there would be less business financing to go around. And that means fewer small businesses, slower economic growth, and not nearly as many entrepreneurs chasing after their big goals.
But what is alternative lending?
How does it work? Who’s an alternative lender, anyway? What’s the difference between alternative and traditional lending?
If you’re asking any of these questions, don’t worry—you’re not alone.
And we’re here to help. Let’s learn more about alternative lending… And how it can make an impact on your small business.
Key Takeaways on Alternative Lending
Don’t have time to dive deep? That’s alright—here are some of the key points about alternative lending.
- The alternative lending industry consists mostly of non-bank companies that provide funding to small businesses.
- Whereas big banks have an approval rating between 13% and 20% over the past 5 years, alternative lenders have accepted on average between 61% and 64% of small business owners looking for funding.
- Alternative lending is a fast-growing industry: approximately $3 billion in 2013 was lent through alternative channels, which was double that of 2012. (And according to one report, online lending—which has a lot of overlap with alternative lending—will be dealing in $200 billion by 2025.)
- Benefits of alternative lenders include less paperwork, more flexibility, and faster funding, though these might come with slightly higher interest rates.
Alternative lending has quickly become a major force in the financial industry over the past few years. And as a result, small- and medium-sized businesses that no longer qualify for bank loans—and might never have, in fact—now have a way to get the capital they need.
Plus, businesses looking for cash right away, instead of in weeks or months, can avoid the notoriously long wait times that banks demand and go straight to an alternative lender, getting funds in days… Or hours.
But while these lending services have been increasing in presence and popularity, many business owners still have misconceptions about the industry—if they even know it exists.
Here are all of your alternative lending questions answered.
What Is Alternative Lending?
Let’s start with the basics:
What is alternative lending, anyway? What’s so “alternative” about it?
The Definition of Alternative Lending
Alternative lending is lending that takes place outside of a banking institution.
Banks are called, on the other hand, ”traditional” financing institutions. When you read about traditional lending, you’re reading about banks—usually big banks—that make large loans, distribute credit cards, give you checking and savings accounts, hand out mortgages, and so on.
So is it a bit biased to call banks “traditional” and everything else “alternative”?
We’re not here to judge—that’s up to you.
But let’s take a look at some examples of alternative lending. Just because it’s “non-traditional,” that doesn’t mean it’s not legitimate.
A Few Examples of Alternative Lending
Depending on who you’re talking to, alternative lending can mean a bunch of different things.
Here are some examples to show you what might fit into that category:
- Microfinance lenders and institutions, like Kiva, that distribute small loans to underserved communities in need of economic development.
- Pawnshops. You might not think of pawnbrokers as lenders, but if you’re pawning an object, you’re essentially taking out a loan with your property as collateral. If you default on your “loan” with a pawnbroker, your credit score won’t report it—but technically, this is a form of alternative lending.
- Money orders and money transfers you make outside of a bank.
- Door-to-door money lending services. Though not always malicious, these lenders often charge extremely high rates to people who have no chance of qualifying for an affordable loan elsewhere. Loan sharks fall into this category.
- Payday loans from shops.
And these are just a few of the many kinds of alternative lending. Banks might feel like the “traditional” way to access credit, but they’re by no means the only option out there.
But something has been happening to alternative lending recently… A change that has given small business owners that all-important access to capital without taking advantage of them, like loan sharks.
That change? The introduction of technology to alternative lending.
Online Lending & Alternative Lending
When we at Fundera talk about alternative lending, we’re usually talking about online non-bank lenders.
Instead of local stores handing out payday loans or pawnbrokers waiting for you to hand in your family heirlooms, these online alternative lenders operate like the lending arm of a bank…
Except they’re much faster and more flexible.
Online alternative lenders use complicated algorithms to underwrite your loan applications quickly, software to scan your business’s financials and sync with your accounting files, and even social media accounts or smartphone records to take some non-traditional sources into account.
Some work like traditional lenders, while others have peer-to-peer models and secondary markets, too.
In other words?
Online lenders are fast, smart, and adaptable. And they’re breaking barriers in the small business financing world.
But why the sudden recent change in what alternative lending means to small business owners?
Alternative Lending’s Recent Growth
Way back in 2007, several of the top alternative lenders—like Prosper, the first peer-to-peer lender in the United States, and LendingClub, the first ever publicly-traded online lender—made a splash in the lending industry.
It wasn’t a coincidence: traditional big banks, and even smaller community banks, had been tightening their belts and handing out fewer loans to small business owners.
Unfortunately, most traditional lenders see small businesses as risky investments—and banks say that small business lending takes as much time and energy as bigger, more guaranteed deals, but with a smaller payoff.
And then, in 2008, the Great Recession rocked the world.
How Alternative Lending Became a Necessary Service
If it was tough for small business owners to access credit from banks before, then after 2008 it was nearly impossible.
In 2006, the top 10 biggest banks in the country lent $72.5 billion to small businesses. By 2014, that amount had dropped 38% to $44.7 billion.
And it wasn’t just the major players in the banking industry, either. In September of 2015, all banks held a total of nearly $600 billion in small business loans—but in 2008, that number had been over $700 billion.
By contrast, loans to large companies increased 37% during the same span of time.
Today, around 1 in 5 small business owners get denied for bank loans. While there are some small signs that banks have been opening their credit back up again, traditional lending still has a far way to go.
That’s where alternative lending comes in.
Alternative Lending: Supplying the Demand
There are two groups of people that needed better access to business financing with the banks tightening their credit…
And these were the entrepreneurs that alternative lenders helped out most—at first.
1. Previously Bankable Business Owners
Since they were less focused on small business lending, banks raised their criteria for business owners who could qualify for their financing.
As a result, business owners who could once rely on a bank loan had nowhere to turn for extra capital…
Or they would’ve, at least, if alternative lenders had also reigned in their financing.
2. Previously Unqualified Business Owners
Alternative lenders also cater to borrowers who wouldn’t have been eligible for a bank loan.
Getting financing from a bank has always been a slow and difficult process: you typically need an excellent credit score, good revenues and cash flow, no history of bankruptcies, and at least two years of business under your belt.
Alternative lenders, on the other hand, accept business owners of all shapes and sizes. In 2015, alternative lenders financed 71% of the loan applications they received—giving many small business owners a chance to develop their companies when a bank would have said “no.”
Over time, alternative lending has been able to cater to other groups of business owners as well, mainly by differentiating themselves from bank lending in more ways than just easier acceptance criteria.
Let’s take a closer look at those differences between alternative lending and traditional bank lending.
How Alternative Lending Is Different From Traditional Bank Lending
When it comes to alternative lending versus traditional lending, there are a few major differences in how they operate—and what that means for you.
Whether you’re eligible for a bank loan or not, there’s no denying the truth:
Alternative lending is much, much faster than traditional lending.
Here are a few reasons.
Since they’re not traditional banking institutions, alternative lenders aren’t affected nearly as much by the government’s regulations of big banks. This is because banks make loans using money from our checking and savings accounts, while alternative lenders get money from other sources—like hedge funds, accredited investors, or secured lines of credit.
Alternative lenders also usually require less paperwork—they don’t ask for a business plan or full financials, for example—so there’s less for you to gather and for them to process.
The technology aspect of alternative lending also plays a big role in its speed. With fast and efficient underwriting programs and highly automated applications, alternative lenders can process many small business loan applications without spending much time or energy.
These financial technology companies have focused on cutting those costs so they can service more small business owners in a smarter way than banks, which don’t rely on fast-paced technology the same way.
Banks offer term loans, lines of credit, and credit cards—the greatest hits of business financing.
But alternative lenders have the time and innovative wiggle room to try out other kinds of loans.
And beyond the kinds of loans you can get, most alternative lenders also make smaller loans than big banks do.
It’s not economical for a bank to make loans less than $250,000, but alternative lenders can easily make loans between $5,000 and $250,000 because of their more efficient processes. With alternative lending, even smaller businesses get the chance to grow.
According to a study by Harvard Business School, most major alternative lenders offer full loan applications online on desktop or mobile that take 30 minutes to complete…
While applying for bank financing takes, on average, 25 hours for a single loan. And that’s not even accounting for the additional weeks—often months—of waiting to hear back, meeting with the bank multiple times, giving in physical paperwork, and more.
For small business owners in the thick of running their day-to-day operations, that time and energy can be a serious barrier to acquiring financing. Alternative lenders offer busy entrepreneurs the ability to secure a loan without sacrificing nearly as much.
While alternative lenders make the lives of business owners easier, they do take on traditionally riskier borrowers—and tend to charge higher interest rates to compensate.
Let’s explain this a bit.
Banks can afford to charge low interest rates because they’re so selective with their borrowers: by only lending to business owners with long and successful track records, banks minimize the risk that their loans won’t get paid back.
Sure, a bank might only be getting 6% interest on that loan, but they’re pretty confident they will receive the whole repayment on time.
Alternative lenders, on the other hand, accept entrepreneurs with shorter times in business, lower credit scores, less proven revenues and cash flow…
Less proof that they’ll be able to repay what they borrow, in other words.
In order to balance the scales out—so their businesses don’t fail when some of these riskier investments inevitably default on their loans—alternative lenders are forced to charge higher rates. That way, even if they only get a portion of the loan repayments, they won’t be in as dangerous a position.
With alternative lending, your interest rate depends on the typical factors like credit score, time in business, annual revenue, and whether you make a profit.
But there’s a wider range, depending on the kind of loan you get: you might snag a 6-15% SBA loan if you’ve got a stellar credit score, or you could be looking at higher double digits with loan products like a merchant cash advance.
The Pros & Cons of Alternative Lending
You’ve probably got a pretty good sense of what, exactly, alternative lending is by now. Some of this might be retreading old ground, but we just want to break it down clearly for you:
When is alternative lending a good idea for your business? And when is it the wrong way to get financing?
Here are the main pros and cons.
The Advantages of Alternative Lending
Alternative lenders really shine where technology can give them a leg-up on banks and other traditional lenders. Their speed, efficiency, and diversity of offerings can make a major difference.
1. Speed & Ease of Application
With technology on their side, alternative lenders have created simple and speedy application processes for smartphone and desktop computers alike.
Applying for a business loan can take as little as 30 minutes, some lenders say—and what’s more, these applications are much easier than their traditional lending counterparts.
Plus, banks sometimes require copies of your business’s financial on paper, delivered in person, but an alternative lender only needs what’s actually important—and you can simply hit the upload button to share those documents with them.
You’ll spend much less time and energy on a loan application with an alternative lender than you will on a bank loan, so if those valuable resources are important to you, this is a major plus on the side of alternative lending. Banks simply can’t compete.
2. Quick Turnaround Time
Their applications are quick—and so is their funding.
Whereas banks can take a few weeks, if not longer, to get back to you about your financing, alternative lenders will often send you their decisions in a matter of days. Some even reply within hours.
Big banks might have the size and money, but alternative lenders can move fast when they need to.
So if you need funding fast to patch up an emergency or take advantage of a business opportunity, or you just want capital in your bank account now instead of in 3 weeks, alternative lending can help.
3. Flexible Underwriting
Alternative lending doesn’t just provide a fast and easy alternative to working with your bank. It reaches a whole new group of entrepreneurs.
Many, many business owners who wouldn’t have qualified for a bank loan at all can access extra capital through alternative lending. With this money, a savvy business owner could invest in a marketing campaign, release a new product, purchase more inventory, hire staff…
You get the idea.
The point is that alternative lending lets small business owners grow their companies in ways they couldn’t when bank lending was the only choice.
4. Diversity of Loans
When you leave traditional lending behind, you open the doors to completely new kinds of business financing.
Whether you want to get paid for your outstanding invoices upfront, get a lump sum of cash and pay it back with your daily credit card transactions, order a bundle of business credit cards to help you build your business credit, crowdfund your business idea, or something else, non-bank alternatives can help.
But don’t worry—alternative lending still offers the classics. You’ll be able to find a term loan or line of credit as well. Just know that there are other options that might actually suit your situation better.
The Disadvantages of Alternative Lending
These are the main cons of alternative lending when compared with traditional lending… But that’s not quite a fair comparison, because after all, very few business owners can qualify for a bank loan.
But if you’re considering whether alternative or traditional lending is right for you, here are some potential negatives to think about.
1. More Expensive
As we talked about not too long ago, alternative lending tends to be the more expensive option.
However, that depends on the products you qualify for and your business’s financials.
If you’re eligible for a Small Business Administration loan, for example, then a bank loan might not be that much more affordable. But if you’re comparing traditional financing with, say, a short-term loan, the price tag difference will be a big one.
In general, though, you can expect to pay more with alternative lenders than you would with a bank.
2. Shorter Terms & Smaller Amounts
In addition to having higher rates, financing from alternative lenders usually—but not always—comes with shorter terms and smaller loan amounts.
Again, it depends on the kind of loan you qualify for, but many alternative lenders cater to business owners who wouldn’t have been eligible for a bank loan…
Which means the financing they can qualify for tends to be smaller, with a shorter repayment period.
The downside to this? Business owners have less time to use that extra capital, and they don’t get as much to spend.
(That said, business owners can “graduate” into better loans by improving their credit scores and building up their businesses, eventually making their way into bigger, more affordable financing.)
3. More Frequent Repayments
As a consequence of shorter terms, many loans given by alternative lenders have weekly—or even daily—repayment schedules.
Bank loans, on the other hand, almost always have monthly repayments.
What does that mean for you?
If you’re aiming to pay off a loan on a daily or weekly basis, you’ll need to carefully plan ahead. If you’re not thoughtful of your business’s financials, those payments could start eating into your cash flow—and potentially endanger your business.
Merchant cash advances are especially risky for this reason. Not only are they the most expensive alternative loans on the market, but they also get repaid with a percentage of your daily credit card transactions.
Not all kinds of alternate loans have daily or weekly payment schedules, though. There are some with monthly schedules, too. It all depends on your business’s financials and the kind of loan you decide to use.
What Kinds of Funding Can You Get From Alternative Lending?
There are a few different kinds of loans you’ll find in alternative lending. Some are straightforward, others take a bit more explanation, but all are useful to be aware of.
Let’s break them down into simple terms.
A term loan is what most people think of when they think of small business financing. These loans have a set repayment time, a set number of payments, and a fixed or variable interest rate.
You can get short-, medium-, or long-term loans—or loans lasting less than a year, between one and three years, and three years or longer.
Lines of Credit
A business line of credit is “revolving,” which means you can draw funds when you need, pay them back, and take out more later on.
You can use your business line of credit to increase your working capital, purchase inventory, cover cash flow gaps, and deal with plenty of other financing needs you might have. It’s a great safety cushion to keep in your back pocket for emergencies or unexpected opportunities.
These loans let you finance up to 100% of the value of the computers, machinery, vehicles, or other equipment you need to run your business. The equipment will act as collateral, which means your lender will care more about its value and less about your company’s financials or your credit history.
Invoice financing, also called accounts receivable financing, gives you an advance on the money you’re already owed, so you don’t have to wait for your clients to pay you before you can cover your own bills.
Dealing with cash flow gaps because of late-paying customers? Need to make payroll but still waiting on an unpaid invoice? Accounts receivable financing can give you more stability—for the price of the interest and fees you’ll pay to the lender.
This is a broad category of alternative lending: different lenders have their own kinds of loans for new businesses without any history. Some startup loans are a bit complicated, like the credit card bundle we mentioned earlier that helps you build business credit, while others are simpler, like the SBA’s microlending program.
You can also look into personal loans for business, where lenders don’t care about your business’s financials—just your personal responsibility as a borrower.
Merchant Cash Advances
A merchant cash advance gives you an advance that’s paid back with a percentage of your daily credit card transactions, plus a lender fee. Merchant cash advances are best suited for companies that do a large amount of their business through credit cards.
On the one hand, this is a useful way to pay back a loan: if you have a slow day, you’ll pay less. But on the other, merchant cash advances are incredibly expensive loans—and we generally advise that you explore other options before settling on one.
Getting Started with Alternative Lending
Small business lending marketplaces like Fundera make it possible to get several offers with one single application. We’re focused on simplifying the business loan process by presenting you with the best-fitting options from the most trusted lenders in the industry.
We take the values of honesty and transparency seriously—that’s why there are no hidden fees, and you’re in complete control of who can see your information. (In other words, you’ll never receive any unsolicited calls or emails.)
For more information on the alternative lending landscape, here are a few of our favorite infographics on the topic:
Orchard Platform’s Online Lending Ecosystem
Accion’s Alternative Lending Landscape
As always, if you have any questions, please drop us an email at firstname.lastname@example.org!
from Fundera Ledger https://www.fundera.com/blog/2016/06/22/alternative-lending/