Natasha Larbie, who owns a construction firm with her husband in Katy, Texas, a Houston suburb, ran into the kind of cash flow problem that many small businesses face. Pearlorm Construction signed several contracts last year for new jobs but wouldn’t get paid until those jobs were done, perhaps months later.
Larbie needed cash to pay for materials and workers. So she turned to online lenders who promised quick, easy financing. Most just asked her how much money she needed, without stating interest rates or time frames for paying off the loan. One offered the cash she needed in exchange for a portion of her sales receipts. The total cost would be $39,200 to borrow $28,000. She took the money, and soon the lender began deducting daily payments from her bank account. She spent six months repaying the advance. “The debt is like a mountain,’’ Larbie said. “It’s an obstacle you have to fight to get over.”
While loans for consumers face strict rules regarding transparent terms and fees, business financing is a virtual Wild West. Online lenders have proliferated in recent years, some of them advertising fast money and ensnaring small businesses in costly loans they don’t understand. There’s enough frustration with online lending that even some online lenders say it’s time to rein it in.
An unusual coalition of business lenders and small-business advocates has been pushing to change the industry.
The Responsible Business Lending Coalition, which includes for-profit online lenders such as LendingClub and Funding Circle, is pressing state and federal legislators to pass laws requiring lenders to disclose the price and terms of their loans in ways any business owner can understand. It says lenders are taking advantage of small businesses by obscuring the details of their loans and irresponsibly lending to borrowers who may not be able to pay them back. The coalition’s demands have special urgency now.
The coronavirus pandemic has threatened the existence of millions of small businesses. More than 1 in 5 business owners went under from February to April. That problem was especially acute for Black- and Latinx-owned businesses, with Black-owned businesses failing at more than double the rate of white-owned businesses.
Many small firms lack the financial resources and access to credit that big companies enjoy. And right now, banks are making it harder for almost anyone to get a loan. As the pandemic-hobbled economy grinds on and banks cut access to credit, the prospects for small businesses get worse, even though they account for nearly half of all private sector jobs.
“For-profit companies are pushing for more regulation because it is good for profits.”
“It’s clearer than ever that if we don’t meet the responsible capital needs of our businesses, the businesses won’t make it and the employees won’t make it,” said Gwendy Brown, vice president of research and policy at the Opportunity Fund, a nonprofit lender that provides low-cost capital to small businesses and a founding member of the Responsible Business Lending Coalition.
The growth of unscrupulous online lending filled a credit void left after the 2008 financial crisis. In the six years following the crisis, bank loans to small businesses dropped 20%, according to a 2014 working paper released by Harvard Business School.
As lending from banks fell, alternative lenders and financial technology (“fintech”) companies with sophisticated algorithms sprung up online. Their online applications were easier to submit and they provided money fast, some of them promising loans in less than an hour. The growth was so pronounced that by 2018, one-third of small businesses had applied for a loan from an online lender.
Some fintech companies use automation to streamline the lending process and lower their costs. Other online lenders simply operate as brokers that shop borrowers around to different lenders. But the Opportunity Fund warned in a 2016 report that most alternative lenders “are peddling short-term and high-cost products that subject borrowers to opaque and often draconian terms, steep repayment obligations, and astonishingly high annual interest rates.”
Although online lenders offer a variety of loans to borrowers with good and bad credit, they tend to market themselves toward those with lower credit scores. In fact, they’re nearly as likely to approve loans for applicants with lower credit scores as those with high scores, a 2019 Federal Reserve survey found.
The survey also showed that Black- and Hispanic-owned firms were more likely to apply through online lenders than white-owned firms. Systemic racism and the lack of access to traditional lending from banks and credit unions “makes our community more vulnerable to other forms of financing,’’ said Anthony Gaddy, president and CEO of the UpState New York Black Chamber of Commerce, which is a member of the Responsible Business Lending Coalition. He decries online lenders for preying on minority-owned businesses.
The idea for the Responsible Business Lending Coalition started percolating in 2014. LendingClub was losing business to unscrupulous competitors offering more expensive products to confused borrowers who didn’t understand the terms of their loans, according to the company’s director of public policy and regulatory, Louis Caditz-Peck. He was growing increasingly concerned about the issue of predatory lending.
Caditz-Peck and Eric Weaver, then head of the Opportunity Fund, drew up a document they called the Small Business Borrowers Bill of Rights. It stated that borrowers have the right to transparent pricing and terms and to responsible underwriting — meaning lenders should assess the ability of a borrower to repay the loan, not just hand them cash and start deducting large payments from their bank accounts without regard to the impact on their businesses.
The next year, the two launched the coalition. Its members now include 65 lending companies that promise to adhere to the bill of rights, as well as more than 35 business groups and advocates pledging support for the document. The coalition is also lobbying for laws that would require other companies to follow similar guidelines.
“For-profit companies are pushing for more regulation because it is good for profits,’’ said Armen Meyer, vice president of regulatory strategy at LendingClub. “The more we are transparent with [customers], the better choices they can make, and the better products win.”
“It’s difficult to win on lower prices,” said Caditz-Peck, “if the competition doesn’t transparently disclose their price.”
One of the biggest bones the coalition has to pick with the lending industry is the lack of disclosure of a loan’s annual percentage rate (APR) ― a calculation of all the fees and interest to be paid, which helps borrowers understand the full cost of a loan and compare the costs of different financing products.
The federal Truth in Lending Act of 1968 requires lenders to report APRs for consumer loans but not for business loans, under the assumption that business borrowers are more sophisticated than consumers.
However, that is often not the case. “We know the vast majority of small businesses are quite small,’’ said Joyce Klein, director of the Business Ownership Initiative at the nonprofit Aspen Institute, a founding member of the coalition. “Many of them do not have in-house CFOs. They have limited capacity to purchase outside expertise.”
Like so many small-business owners, Larbie and her husband make financial decisions for Pearlorm Construction on their own. She turned to online lenders after Bank of America and other banks rejected her application because her business was then less than two years old. (Banks often require that businesses have at least two years of operating history to qualify for a loan.)
She got a type of loan often called a merchant cash advance, in which the borrower sells a portion of future sales for a set dollar amount, paid off as a percentage of sales. The payments are deducted sometimes daily or weekly from the borrower’s bank account, so that the lender gets paid before anyone else.
“If you really need the money, you feel like you don’t have any choice.”
Since those loans don’t have a set time frame and may last for only a few months, the lenders typically don’t report an APR. That makes it hard for the borrower to compare these loans against other options.
Depending on the speed of repayment, the effective APR on a merchant cash advance may exceed 80% or even rise to the triple digits. When the Opportunity Fund calculated APRs for online alternative loans like these in 2016, the average was 94%. The highest reached 358%. (Traditional bank loans and loans guaranteed by the Small Business Administration typically have APRs under 15%.) The average monthly loan payments were nearly double the profits available to the owner of the business.
Larbie’s agreement for a cash advance of $28,000 allowed her lender to take 15% of her monthly sales from her bank account, up to $39,200.
“If you really need the money, you feel like you don’t have any choice,” she said.
Some online lenders, such as LendingClub, disclose APRs and other terms online, often touting their lowest possible rate upfront and including the full range of APRs in a footnote. Some lenders won’t even disclose that.
This summer, the coalition and other lenders successfully pushed for the passage of a New York state law that requires online lenders to clearly disclose the cost of small-business loans (it is still waiting for the governor’s signature). The coalition estimated that more complete financing disclosures, including APRs, will save businesses in the state $369 million to $1.78 billion annually.
The win follows a similar law written by California state Sen. Steve Glazer (D), who was inspired by the coalition’s bill of rights. His measure passed the California legislature in 2018, despite opposition from some alternative lenders and merchant cash advance companies. It hasn’t been implemented yet.
These state laws can improve transparency and reduce deceptive advertising, said Michael Barr, director of the University of Michigan’s Center on Finance, Law and Policy, who advised the coalition in its early days.
But they don’t address everything the coalition wanted, including requiring online lenders to underwrite borrowers to ensure their loans can be paid back without destroying the borrower’s business.
Many in the industry, including PayPal — which is not a member of the Coalition — argue in public documents that borrowers frequently don’t understand APRs and how to calculate them, so they are not useful. (PayPal did not respond to a request for comment.)
For instance, the “annual” aspect of an “annual percentage rate” makes the financing of shorter-term lending products look deceptively high because the APR is what you’d pay if the credit lasted a year, not a few weeks or months, said Scott Talbott, senior vice president of governmental affairs for the Electronic Transactions Association, a trade group that lobbies on behalf of hundreds of fintech and credit card companies. Talbott is concerned about any law requiring APR disclosure for business lenders. Instead, he favors a “total cost of capital” figure that tells borrowers exactly what they’ll pay in principal and any fees for financing. (Like what Larbie got.)
Still, the Responsible Business Lending Coalition is pushing a bill in the U.S. House that would force business lenders nationally to disclose APRs, fees and terms for business loans. It’s sponsored by Rep. Nydia Velázquez (D-N.Y.), the chairwoman of the House Small Business Committee.
“I’m hopeful this is the beginning of a process that will lead to federal legislation that looks out for the interest of small businesses,’’ Barr said. “[The coalition] has made progress. I do think there’s a lot more work to do.”
Greater transparency and standardized reporting practices might have helped Larbie understand exactly what she was getting into. If her lender had been required to give her an APR, she might have figured out it was cheaper to borrow on a credit card. Months after paying off the loan she took out last year and another from 2018, Larbie still gets text messages and phone calls, sometimes daily, from brokers and lenders she’s never heard of asking her if she needs money.
She regrets her decision to take out a merchant cash advance, which she said was confusing and expensive. “But if you’re desperate,” she said, “there are repercussions.”
CORRECTION: An earlier version of this story misidentified Michael Barr.
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