With banks being increasingly reluctant to lend to small businesses and government stimulus close to running its course, small businesses are turning to alternative forms of borrowing.
The market for alternative lending has been growing quickly over the past decade, in part because of the development in financial technology that allows for creative ways to secure assets, process applications, and automate funding.
Let’s take a look at the five most popular loans for small businesses:
It is back-to-basics, being the classic, default business loan from banks – though many online lenders use them too. Secured loans are termed this way because the borrower must secure the loan to existing collateral.
How secured loans work is essentially by using assets to secure the loan, such as a car, personal home, or anything that holds clear and consistent value. This is so the lender can repossess and sell the asset in the event of failed repayments. This security lowers the risk profile of the loan in the eyes of the lender, meaning that the interest is lower as a result.
The issue many people have with secured loans is keeping the collateral focused on business assets and away from personal assets. Otherwise, this could deeply impact their personal and family lives.
Secured loans are often under 10% in interest, making them the cheapest form of loans. Furthermore, larger companies prefer these because secured loans usually allow for greater loan amounts, making them ideal for long-term projects and gearing. Of course, approval can be easier than with unsecured loans because of this reduction in risk.
On the other side of the same coin is how unsecured loans work. These are loans in which no personal or business assets are under threat of repossession. This alone makes it a preferable loan – but there are other factors to consider.
Because of this increased risk, there is a premium price to pay. Interest rates are often higher – usually 10% and above. However, this can be worth it for many, particularly for those who do not have many assets to use as collateral.
Unsecured loans are usually a lot more flexible. The terms for repayments are often highly negotiable, with the potential for very short repayment terms, as well as the ability to borrow a small amount.
This makes them perfect for small businesses who want quick, small loans with less paperwork. Due to their smaller size, the higher interest is often not seen as a complete obstacle either. Whilst they are traditionally more difficult to attain (credit history becomes more important), many online lenders are simply accepting those with average credit but price up the interest accordingly.
How invoice factoring works can be a confusing topic due to the term “invoice discounting”; we’ll get to the latter term after exploring the former.
Invoice factoring is where online lending has innovated and found creative new ways to increase the security of loans, meaning they lower the risk, but without jeopardizing borrower’s personal assets.
Invoice factoring is a way for firms to use their invoices (account receivables) to receive instant cash funding. Essentially, you hand over your invoices that are due to a third party, who will then take on responsibility for collecting them. Of course, you don’t receive the full amount of the total value of the accumulated invoices.
Often, businesses will receive around 60% to 80% of the total value, and then sometimes some extra money once the invoices have been fully settled. However, the total funding will always be smaller, because the third-party collectors need to be paid for collecting these invoices plus the risk of the invoices not being settled.
This is a fantastic way to liquidate invoices and get a quick cash injection for very little risk – there are no repayments to miss, and no personal assets as collateral. However, some businesses are deterred because they don’t like handing over the invoice collecting management to a third party, whose practices may be unknown, and clients may feel this is aggressive and confusing.
To avoid this, invoice discounting exists. This is extremely similar, but the business retains full control over collecting the invoices.
Business Overdraft and Line of Credit
Whilst it’s fairly intuitive to understand how business overdrafts work, it’s important to recognize they can be both secured and unsecured, but there are often significant establishment and annual fees for unsecured overdrafts.
Overdrafts allow you to spend money you do not have, but can quickly incur fees and the limits are usually stringent. Lines of credit are more similar to a credit card, in which a certain amount is pre-agreed (usually more than a typical overdraft), and can also offer overdraft protection.
Lines of credit are usually unsecured (but they can be secured), and you only pay interest on the amounts you use (though there are fees regardless). This makes them highly flexible and accessible, but the interest is generally quite high. The credit is usually offered for 12 months, which it should be fully repaid for when it expires.
These are great if you’re expecting cash flow issues, but don’t know exactly when or if they’re for definite. The ongoing fees can then be viewed as a kind of insurance, and the interest is only paid when (or if) you use some of the funds. However, if funding needs are more certain, other financing options may be cheaper.
Secured loans against the asset purchased
There have been more twists put on the secured loan, and one of them is to use secured assets in a way that’s more appealing to the borrower. For example, when we take a look at how business car loans work, we can see that it’s often the case that borrowing funds for a car purchase mean that the lender owns the car until you fully repay the loan. Or at the very least, they’re entitled to repossess the car should you fail to repay.
This seems more appealing than jeopardizing your home or personal car, because this asset isn’t even something you have yet paid for. The same dynamic exists for equipment financing (i.e. purchasing new machinery), which is a great way to secure a loan with an asset that you’re specifically using the loan for – it just makes sense for expansion projects that are difficult to bootstrap.
Of course, there are some downsides, such as potential restrictions on the equipment. For example, there is sometimes a limit to how many annual miles you can drive the car, so the borrower can ensure it retains value regarding being sufficient collateral.
Interest rates are higher than traditional secured loans too, though they are arguably cheaper than many other financing options on this list still.
Whilst the situation regarding credit isn’t particularly healthy going into 2022, there is at least one promising trend: options are increasing. Choice is important for any consumer, and the loan market feels like it’s being democratized and decentralized away from banks. As more options arise, small businesses can more easily find a funding option that suits their specific needs.