For some small businesses, alternative financing is all that is doable. But not every alternative lender is the same. There are big differences between the types of loans, the terms and the rate you’ll pay to borrow, so know what you are getting into before signing on the dotted line.
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"Alternative lending is unregulated, which can create pitfalls," says Scott Griest, CEO at alternative lender American Finance Solutions. “Small businesses have to be careful who they choose to partner with.”
The great recession hit small businesses hard, and many banks weren’t willing to lend. That ushered in a crop of alternative financing companies that are willing to lend money much quicker than a traditional bank. Often the interest rate on the loan is going to be higher than a bank, but according to Griest, the increased competition is bringing the rates down somewhat.
“Over the past 24 months the yield has dropped at least 20%,” says Griest. “Competition is driving the adoption of technology that makes the service and application process much quicker.”
Still, small business owners have to go into this type of borrowing with their eyes wide open. Not only will they pay more in terms of the interest rate, but they have to make sure the lender has their best interest at heart.
With that in mind, here are five pitfalls to look out for when it comes to alternative financing:
Pitfall No. 1: Upfront fees
If you are using an alternative lender you should be aware that the rate you pay to borrow the money is going to be higher than at a bank, and you also face upfront fees that can make it really expensive to take out that loan.
“You shouldn’t be spending any money to get the deal done,” says Griest.
Pitfall No. 2: Going with a broker instead of direct
Just like there are brokers in the mortgage industry and in the insurance market, the same holds true of the alternative lending industry. While not every broker is focused solely on their commission, many are, and won’t care what product they put you in as long as they get a commission.
“For equipment leasing or merchant cash advances those brokers are getting a commission on the transaction that can be 8% to 12% which can drive the cost of the funding up,” says Ethan Senturia, chief executive of DealStruck, a small business lender. He says small business owners are better off going with a direct lender than getting involved with a middle man.
Pitfall No. 3: Getting the wrong type of loan
There are all sorts of ways small businesses can borrow money through an alternative lender, but choose the wrong product and you could end up with an even bigger cash flow problem. According to Griest, a lot of times the loans will be structured as short-term contracts. This could hurt a small business that needs to borrow $20,000 to remodel, but then has to pay the loan back in less than six months. To avoid that from happening, Griest says to go with a lender who will take the time to understand your business, look at your total cash flow and gives you ten to 12 months to pay it back.
Pitfall No. 4: Going with a shady lender
When buying from any sort of lender you want to go with someone who is reputable and has been in the business for a while. According to David Goldin, president of the North American Merchant Advance Association and president and chief executive of AmeriMerchant, while the industry isn’t regulated it is self-regulated through his trade group. Members of that trade group agree to follow best practices, such as disclosing all fees and not allowing a small business owner to have two loans at once, which could hurt his or her cash flow.
“There’s a lot of ins and outs and a lot of people charging high rates,” says Goldin. He says to go with a company that has been in the business for at least three years and who doesn’t require a repayment after three months.
Pitfall No. 5: Unclear pricing
If a lender isn’t clear about how much the loan is going to cost you, it’s a red flag that you may be over paying. Senturia says to avoid lenders that won’t tell you the annual percentage rate or otherwise try to hide the total cost of the loan.
“A lot of times lenders don’t quote on an interest rate basis or they don’t quote on an annualized basis,” says Senturia. “Some lenders might say we will give you $50,000 at a 1.3 buy rate and you might think that’s 30% interest rate, but since the loan is only for four months you are really paying 90%.”