What Is Alternative Lending?
Traditional banks aren’t your only option anymore.
- December 5, 2019
- 9 min read
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One of the biggest benefits of new technologies and innovation in finance is the emergence of alternative lending, especially for small business owners. In the past, small business owners had no choice but to go the traditional route of going to a brick-and-mortar bank, lender or the Small Business Administration for business finance. These forms of funding, while offering favorable loan terms, are extremely difficult to acquire, carrying strict requirements and low rates of approval, especially for startups.
Alternative lending is the result of technological advances. Thanks to the internet, financial institutions can operate solely online without having to support the expensive overhead costs of running a physical branch network. This advantage enables alternative lenders to loan money to riskier borrowers or those who don’t yet have the credentials required by traditional lenders.
Read on to find out what alternative lending is and all the various types you can choose from for your business.
Alternative lending refers to business lenders that are not included among traditional lenders like banks and SBA loans. Rather than typical long-term loans from a bank or the SBA, alternative lending usually takes the form of short-term business loans, medium-term business loans, personal and business lines of credit, invoice financing and factoring, equipment financing and merchant cash advances, among others. Consequently, alternative lending provides a wider variety of funding options than had been traditionally available in the past.
To be clear, many types of alternative lending mentioned are also offered by traditional business lenders. The main difference, however, is that alternative lenders typically have less strict approval qualifications, such as less time in business and lower annual revenue requirements, which makes these loans available to types of businesses who would otherwise be rejected by traditional lenders.
Many of the top alternative lenders are online companies that can afford to make money more accessible to business owners. One of the principal reasons for this is that online lenders usually don’t have the high costs of operating brick-and-mortar branches like a traditional bank.
One of the best aspects of alternative lending is the diverse set of options business owners can choose from.
Here are some different types of alternative lending options:
Online term loans are not that different than bank loans that you can get with traditional small business lending. The most notable difference is that online term loans generally come with shorter repayment terms, often ranging from just a few weeks to a few years. It can be very difficult finding a short or medium-term business loan from a bank or credit union. In this regard, online term loans can be particularly useful for a small business owner.
Online term loans usually provide fast funding and easier requirements than bank loans, but they also tend to come with higher interest rates and fees. So, keep your eye on the expense of online term loans if you decide to go down this road.
When it comes to equipment financing, you can usually get comparable terms from both traditional and online small business lenders. In the case of equipment financing, your business uses a piece of equipment or vehicle as collateral for the loan. This makes this form of alternative lending less risky than unsecured forms of business loans.
By putting up collateral, however, you stand to lose your equipment if you fail to repay the loan, or worse, your business fails. This is one notable area in which an unsecured form of credit could be a better option. Learn more about all the various types of equipment financing available and your eligibility.
Invoice factoring is a form of alternative lending in which your business sells an outstanding invoice in your accounts receivable to a third-party company. In this arrangement, you receive a percentage of the invoice you sell to the third-party company while the third-party company — called the factoring company — takes the remainder of the invoice.
Invoice factoring is distinct from invoice financing. Invoice factoring is actually an advance given to you by the third-party factoring company, rather than a loan like in invoice financing. Also, in invoice financing, you pay back the lender. In invoice factoring, however, you give the factoring company the right to contact your clients directly to collect unpaid invoices, which could negatively impact your business relations with them. What’s more, with invoice factoring, you might not get as much business funding as you would with invoice financing. The top advantage with invoice factoring over invoice financing is that, since it’s not a loan, your creditworthiness isn’t a requirement.
A business line of credit can be acquired from both traditional business lenders and alternative lenders. With traditional lenders, however, a business line of credit comes with long repayment terms, whereas alternative lenders can provide short and medium-term funding. As a small business, you might only need to access a credit line in the short term. You also might want to avoid carrying revolving debt, which could lead to paying interest in the long term, too. In this case, your best move could be to compare terms with multiple lenders and zero in on the business line of credit that fits your needs and time horizon.
Vendor credit is a form of alternative lending in which you purchase goods or services from vendors that allow you to buy now and pay later. The most common form of vendor credit is a net-30 account, which gives you 30 days to pay the bill after you’ve already made the purchase from the vendor. Though net-30 is the most typical, terms of net-15, net-45, net-60 and net-90 days exist as well.
With vendor credit, you usually don’t have to pay interest, but even if you do, the cost is low compared to other forms of lending. Vendor credit is a great way to build a strong business credit profile if the vendor reports your repayments to commercial credit agencies, such as Dun & Bradstreet, Experian and Equifax.
A merchant cash advance a form of alternative lending that, like invoice factoring, is technically not a loan, but an advance. In a merchant cash advance, you receive business funding as an advance on your company’s future credit and debit card sales. Since getting the advance depends on future sales, your business’s cash flow is important for securing this type of funding.
Merchant cash advances are generally easier to acquire than other forms of lending because the advance is secured by your cash flow. As a result, if you can’t show solid revenues from credit and debit card sales, you’ll likely get denied for a merchant cash advance. What’s more, merchant cash advances are widely known to be expensive, with APRs often ranging from 20 percent to 250 percent. In fact, the APR on a merchant cash advance isn’t represented as a percent, but as a decimal figure called a factor rate because all of the interest is charged to the principal when the advance is originated, rather than paid as interest accrues on the principal over the course of repayment.
Made widely popular by websites like Kickstarter, crowdfunding is a comparatively new form of alternative lending for small businesses. Crowdfunding is designed to connect new business owners with potential customers, giving your business the opportunity to demonstrate your product or service while inviting consumers to donate money to help get your company up and running.
Securing business finance for a startup, with no proven revenue or history, is notoriously difficult. Crowdfunding can be a great for startup business owner because it entirely bypasses traditional lenders and avoids the trappings of business loans like interest rates and fees. With crowdfunding, your business receives money directly from the people who you want to become your customers, and your main liability is to eventually provide them with the service or product you want to sell.
Using business credit cards to fund your business is a form of alternative lending that is often overlooked. There are many advantages to using business credit cards for business finance since they don’t require a certain amount of time in business or minimum annual revenue. Knowing how credit cards work, with a revolving line of credit, can be helpful for ongoing working capital needs while providing greater flexibility than term loans.
Business credit cards often charge APRs of over 20 percent depending on your credit, but when compared to other traditional and alternative lending methods, such an interest rate isn’t too bad. Plus, you can avoid paying interest altogether by paying your balance in full each month. Like many personal credit cards, some business credit cards offer perks and benefits such as a cash-back rewards program and/or introductory 0% APR promotions. Review some of the best small business credit cards available to fund your startup.
Like any form of business financing, alternative lending carries with it both advantages and disadvantages. The form of alternative lending you choose naturally influences the benefits and drawbacks you’ll deal with.
Here are some of the main positives and negatives you may encounter with 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 here’s a clear breakdown of the advantages of this type of lending so you can evaluate if it’s right for you:
- Speed and ease of application: Thanks to technology and lower overhead costs, alternative lenders have crafted faster and simpler application processes, accessible on different devices like a desktop computer, mobile phone or tablet. Applying for a business loan can take less than an hour and usually these applications are much easier compared to traditional lending applications. What’s more, it is common for banks to require copies of your company’s financial statements on paper and delivered in person, whereas alternative lenders usually accept these documents online.
- Fast funding: Quick access to funding is a major selling point of alternative lending since banks can take several weeks or longer to give you an answer about your business funding. Alternative lenders very often can get back to you with their decisions in a matter of days, sometimes hours.
- Flexible underwriting: Many small business owners who can’t qualify for a business loan from a bank can obtain funding through alternative lending. This is due to both less stringent lending requirements and the variety of options you have to choose from.
- Diversity of funding options: Traditional banks and lenders cannot beat alternative lending when it comes to the diversity of loans and financing options they can offer. Whether it’s invoice factoring, equipment financing or business merchant cash advances, these non-bank alternatives can be a huge boon to a startup business owner who is unlikely to qualify for funding the traditional routes.
If you’re considering whether alternative lending is best for you, here are some potential negatives to think about:
- More expensive: This is perhaps the disadvantage that stands out the most about alternative lending. Since you likely couldn’t get a business loan from a bank, alternative lenders account for this increased risk by charging higher interest rates and fees than traditional lenders. That being said, the cost depends on the alternative lending product you choose, and in some cases, your personal and business credit scores.
- Shorter terms and smaller amounts: Financing through alternative lenders usually comes with shorter terms and smaller loan amounts. This means the business funding you can qualify for tends to be smaller, with a shorter repayment period. These terms can put pressure on small business owners because they have less time to use the capital while at the same time not getting as much to spend either. Depending on your needs, this may be fine or it could be a deal killer.
- More frequent repayments: As a result of the shorter terms offered through alternative lending, you also have tighter repayment schedules, such as weekly or daily repayments. Traditional business loans from a bank usually always have monthly repayments. In alternative lending, the short time-frame requires some strategic planning for your finances because you don’t want the tight repayment schedule to cut into your cash flow.
Alternative lending tends to be more expensive than traditional ways of getting small business funding. But thanks to its less stringent requirements, alternative lending has proven to be a great route for entrepreneurs and early-stage small business owners to get the funds they need to run their company. The type of alternative lending you pursue — whether it is equipment financing or a merchant cash advance — depends on what makes sense for you and your company. The main takeaway, however, is that you do have a variety of options beyond big banks, traditional lenders and SBA loans to start or run your business.
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