It’s an indisputable fact: alternative loans are expensive. Be it a term loan, a merchant cash advance, or a more flexible line of credit—any alternative lending option is going to cost you more in interest and fees than a traditional, government-guaranteed SBA loan or commercial bank loan.
But when you need funding fast (or if you have bad credit or no collateral), a traditional loan just isn’t option. You’ll have to explore the new “world” of alternative lending to get your working capital. As you're shopping, though, keep in mind one huge flaw in the industry that continues to hold small business borrowers back: lack of price transparency.
Alternative lenders aren’t regulated by the Federal Deposit Insurance Corporation, so they are not held to the same standards as traditional banks in terms of price transparency—but brokers and lenders do hold some ethical responsibility for educating their customers and writing loan agreements in plain english. You shouldn’t need a PhD in finance in order to feel confident both in the quality of the loan and your own ability to pay.
In order to feel comfortable taking on an alternative loan, you need to clearly understand all of the associated interest rates and fees that accompany the terms of the agreement.
Here are three common questions you should ask lenders to answer clearly so you can understand the true cost of the loan:
1) What is the origination fee?
The loan’s origination fee is a cost charged by the lender when the loan is first created. Typically, it is expressed in terms of a percentage of the loan amount. The cost of the fee is usually held back when the loan is funded, but still included when calculating the principal, interest rate, and total capital to be repaid.
2) What is the effective APR?
When you’re first told the interest rate of a short term loan, you might automatically interpret that number as the APR or annual percentage rate—a pricing structure that is likely familiar from longer term mortgage or education loans. You may not realize that with short term financing, the length of the loan dramatically impacts the effective APR.
For example, if you’re offered a 20% interest rate on a four month loan, your actual effective APR on the loan is 60%. That’s a huge difference! Brokers should explain the impact of loan terms when helping you understand your interest rates.
3) What, if any, prepayment penalties are attached?
It’s likely you might assume that paying back alternative loans ahead of schedule will save money. After all, common sense would dictate that a shorter overall loan period translates to less interest paid. However, some alternative lenders actually attach penalties for borrowers who pay their loans faster than the agreed term, effectively canceling any savings from prepayment.
What could be more disheartening than going the extra mile to pay a loan ahead of schedule, only to realize you’ll be penalized for doing so and not garner any savings? Be sure to ask any potential lender if they include prepayment penalties in the terms of the loan.
To be clear, a traditional, FDIC-insured loan is almost always the best option for those who qualify. That’s why honest, forthright alternative lenders should be working to help you graduate to bank loans as your business assets, collateral and credit become established. But in the meantime, in order for alternative loans to be a valid option, lenders must do more to create a user-friendly and transparent pricing experience. Until they catch up, you can come prepared with the right questions to discover the true cost of your capital.