Traditional Banks vs. Alternative Lenders

Traditional Banks vs. Alternative Lenders: The Pros and Cons of Each Model

By Daniel Lewis

In the past decade, a sleuth of alternative lenders has emerged which are disrupting the traditional loan model. Historically, one of the only ways to gain finance was to go through a bank. Now there are hundreds of reputable online alternative lenders that can serve to facilitate a loan within a day. Both alternative lenders and bank loans have their advantages and disadvantages.

While many business owners lament the fact that rates for loans are so high, it must be considered that 17% of all SBA(7)(a) loans go into default.  Despite the fact that banks are still the preferred option for small business owners, alternative lenders are gaining ground.

Bank Loan Advantages

Banks are still the most common place to go to find small business loans. And many of those who are applying to alternative lenders are actually businesses that could not attain a loan with a bank. The reason for this is that bank loans offer the best rates of interest compared to alternative lenders.

The most common kind of bank loan is the SBA (7)(a) aimed towards small businesses (less than 500 employees). The loan is 85% guaranteed by the Small Business Administration (SBA) in an attempt by the government to encourage small business lending and bolster the economy. It is banks that facilitate the lending, the SBA just guarantees in case of default.

The main benefit of the SBA (7)(a) is that the interest rates are lower. Additional benefits are that the term lengths can be quite generous, such as 10-year terms on non-real estate loans. Moreover, the SBA (7)(a) allows for projection based underwriting.

What this means is that a loan can be obtained based on the projected profits of the business. This is generally not possible with alternative lenders. So there is a lot to be said for these SBA loans and there is a reason why so many businesses are trying to get them. Property loans are also one kind of loan where banks are better equipped to provide finance compared to alternative lenders.

Bank Loan Disadvantages

But there are serious drawbacks. The primary drawback is the lengthy approval process which involves an incredible amount of business documentation. It can take a long time to get all of this documentation together. In fact, there is most likely going to be some documents that you cannot get your hands on, and there may be a lot of back and forth in negotiations with the lending institution with regard to these files.

Once you do have all the documentation settled, expect to be waiting months for a response. And it is most likely going to be no. The approval rate for small business loans from big banks is not high. But at 27% it is high by traditional standards, according to the latest Biz2credit monthly report. Small bank approvals are around 50%.

SBA (7)(a) loan applicants are often required to put up their personal assets as collateral for the loan, which is another major drawback.

The SBA (7)(a) also comes with prepayment penalties. This means that businesses have to pay interest when they are able to settle their debt early. While this might sound harsh, financial institutions need to budget and make plans based on projections of estimates, and early payment can upset these projections. Additionally, these prepayment penalties only apply if the payment is more than 25% and is made within 3 years in the instance of SBA (7)(a) loans.

Alternative Lender Advantages

There is now an alternative lending arrangement to suit every business enterprise. One of the primary advantages of the entire class of alternative lenders is flexibility and customization with lines of credit, merchant cash advance, term loans, invoice factoring, asset finance,  and more.

Your business needs to meet very basic requirements to qualify for a loan. For example, with Kabbage, you simply need to have a credit score of 560, a year in business, and an annual revenue of $50,000. This is enough for a business to qualify for a business line of credit or a term loan.

These requirements are similar to many reputable online vendors, such as OnDeck or Fundbox. Fundbox is one of the easiest platforms to qualify for. The platform does not even require a credit score, just two months activity in a supported accounting software or 3 months in a business bank account. A $50,000 minimum is required and invoice factoring is also on offer.

The best part is that the application process can be done in just minutes. You can find out very quickly whether you will get the loan or not, and the funds will be in your account within the next business day in most instances. In other words, if you want money in your account today without any of the stress associated with bank loans, then alternative lenders are the way to go.

They are perfect for business loans for bad credit and are also better for acquiring an unsecured business loan. Banks nearly always require a good credit score, despite stating that all applicants are welcome to apply. Alternative loans can also offer no prepayment penalties in many instances.

The alternative loan model has distinct benefits compared to bank loans – limited credit score, low annual revenue, little documentation, 5-minute approval, no prepayment penalties, and 24 hours for funds in the bank. Additionally, banks do not deal with low cash figures, while alternative lenders do.

Alternative Lender Disadvantages

The primary disadvantage associated with alternative lenders is that the interest rates are higher as compared to banks. Also, the term lengths can be a lot shorter, which can put considerable stress on new businesses. Alternative lenders are not as effective in terms of increasing a credit rating. Some may not update your credit report while this is always done with a traditional bank.

Because many alternative lenders provide short term loans (less than 12 months), it can have some tax implications. As all interest payments are made in a single year, you cannot claim a tax deduction until a future year.

Another thing to be aware of are hidden fees with some alternative lenders and the fact that these lenders could go out of business. Though in practice, the bigger alternative lenders are unlikely to go bankrupt. Lending Club, for example, has facilitated over $120 Billion in loans during 2017. Its 2018 report is set to dwarf this figure.

Which Model is Best?

The two models each have distinct advantages and disadvantages, and it often depends on the person and type of business. For many, the ability to access instant finance with flexible terms and conditions on the alternative market is quite lucrative. Alternative lending is perfect for startups and small businesses who want to maximize their growth without going through any unnecessary hoops. The fact that there are often no prepayment penalties and no collateral required is also very appealing.

Small businesses older than 3 years with a good credit score and a profitable revenue stream could benefit from the SBA (7)(a) bank loan. They will have a good chance of getting it. But at this stage, they are no longer in need of funding. Ironically, the SBA(7)(a), designed to help small businesses, seems to help small businesses who no longer need help. This is part of the reason for the increase in alternative lending platforms.

Daniel Lewis
Daniel Lewis
Daniel Lewis is an MBA accredited investment professional who wants to assist small business owners to gain access to finance. After going through many channels for funding, Lewis has found that getting the first loan right is vitally important for future success.

Finimpact matching you with the world’s top funding providers.

It’s quick, easy and free – Small Business Funding.
Check if you qualify in 30 sec!