Traditional vs Alternative Lending Explained
There are countless small business enterprises opening every day, and each one is unique. But one thing they all have in common is the need for capital. All businesses need money to grow, especially small businesses just getting up and running. Having access to capital is imperative to the growth of a small business, and borrowing money is often the catalyst to that growth. A traditional bank or credit union used to be the only option for a small business loan. But with the rise of alternative lending, there are certainly other options to consider.
Two of the main differences between traditional and alternative lenders is who they will loan money to (based on risk) and how quickly they will get the money to you. Here’s the skinny on those factors as well as a few others below:
Traditional banks are pretty risk-averse. They base their loan decisions off of your payment history, your credit score, cash flow history, and projected earnings. They also tend to feel more comfortable when you have collateral to pledge against any money you borrow. For new businesses, this can be problematic. You need a loan to make all of those things possible in the first place!
Alternative lenders, on the other hand, assume most of the risk. They are more open to businesses with poor or non-existent credit, and generally have options for those with bad credit scores, making it easier for businesses with little to no history to obtain cash. Alternative lenders are also able to circumnavigate around issues such as bankruptcy, tax liens, negative balances, and smaller deposit frequency with ease, which is something banks don’t usually accept within their underwriting guidelines.
Pros and Cons: Traditional banks can be harder to work with, but usually allow you to stretch your payments out with a longer term and offer lower interest rates. Alternative lenders aren’t as picky about who they give money to, but typically require faster repayment with higher interest.
Traditional banks often have a long application process with many back-and-forth discussions negotiating terms and eligibility. It nearly always takes 4-12 weeks for the funds to be made available.
Alternative lenders are known for their quick turnaround time. They can seek approvals in a matter of just hours and make the ACH transfer to their clients in as little as 24-48 hours.
Pros and Cons: Alternative lenders are above par in this area, being a superior choice for new businesses that need startup capital quickly. One caveat: do your research. Lightning-speed turnaround is great, but make sure you’ve done due diligence to ensure your alternative lender is reputable.
Traditional banks will generally provide you with terms under an APR structure or Annual Percentage Rate. This rate is roughly the cost of borrowing under the consideration that you would be borrowing for 12 months. Most of the time, a bank or traditional lender will provide term lengths that far exceed 12 months, which is where they make the lion’s share of their money. The remittance structure is usually once per month that you’ll need to make your loan payment.
Alternative lenders often provide you with a factor rate, which still represents the cost of borrowing except depicted in a fixed fee. For instance, if you get advanced/funded $100,000 at a factor rate of 1.2, then the total amount you would remit at the conclusion of your term length would be $120,000. This is generally fixed, but here at Strategic Capital we go above and beyond to actually provide incentives when a merchant repays early! That’s unheard of in traditional banking, as they’ll usually instate a penalty for pre-payment as opposed to an incentive. The remittance structure on the alternative side is usually daily or weekly payments, as opposed to monthly.
Pros and Cons: The rates a bank or traditional lender will offer will usually be lower. They’ll also give you more time to repay. However, there can be a lot of hidden interest that’s not accounted for or clearly communicated on the front end. Also be careful to sign up for a loan that locks you in for the full length of the term with no potential to repay early. Alternative lenders cost of borrowing can be a bit higher, but it’s via a fixed daily or weekly repayment that takes the confusion out of the borrowing process. By going through a firm such as Strategic Capital, you can ensure that if you choose to repay your balance early, you’ll receive incentive for doing so!
Origination & Underwriting Fees
Traditional banks will present their fee structure as a percent of the origination amount, which means the higher the approval, the higher amount they’re shaving off the top in fees. Since banks charge lower interest rates than the alternative sector, they opt to make more money within their fee structure. “Nickel and diming” would be a very descriptive and fitting term.
Alternative lenders will usually just charge a flat origination or processing fee. A good example would be borrowing or getting advanced $200,000 and having a $500 processing fee and a $650 origination fee as opposed to a larger 2-3% specified on the front end. The fees are taken out of your total approval amount. For instance, if you get approved for $100,000 and the total fees are $800, you would receive $99,200 deposited into your account.
Pros and Cons: Although banks generally offer lower interest rates, they’re out to make a killing on their fee structure. Alternative lenders charge higher interest and factor rates, however their fee structure is usually much more palatable. With either, there’s usually no out of pocket costs as the fees are just paid from the borrowed or advanced amount. If you ever feel you are at risk to miss payments or default on your loan or advance, always call the lender ahead of time because in both industry sub-sectors, they’ll administer additional fees for such shortfalls, and if you notify them ahead of time, you can often setup an arrangement to avoid those fees.
Whichever route you decide to go, know that you have options. Don’t be discouraged if your bank or credit union turns you away! By researching a reputable alternative lending firm, you can get the cash you need to take your business to the next level.