By Ken So
Small businesses, especially the newest, smallest businesses, can face challenges when trying to secure financing through traditional banks and credit unions. If you own one of these types of businesses, then alternative funding can be a viable option to meet your financing needs.
Of course, as with any type of funding, there are certain things that you should be aware of before signing a loan agreement. In this article, we’ll explore what alternative lending is, how it differs from traditional lending, and what to know before applying.
What is alternative lending?
Alternative lending refers to any type of business financing that doesn’t come from a bank or credit union.
With the rise of financial technology lenders, “alternative lenders” have become synonymous with startups and online loans. However, while non-bank lenders can be fintech companies or online lenders, they don’t have to be.
Many alternative lenders have small business loans or other business funding products that fall outside of those offered by traditional financial institutions (ie, business lines of credit and loans). They tend to specialize in specific use cases (like equipment financing) and/or industries (such as e-commerce).
Many also use unique methods to assess a business’s creditworthiness and its ability to repay borrowers, usually taking into account factors beyond traditional underwriting and credit scoring models. This means that entrepreneurs with bad credit can often increase their funding options when they open up their search to the alternative lending industry.
How is alternative lending different from traditional lending?
Alternative lending is a broad category, and so it is difficult to highlight specific differences. However, there are some general points that we can cover.
For one, alternative lenders tend to have less stringent requirements for loan approvals than traditional lenders. They may consider non-traditional factors such as a borrower’s invoices and/or future growth potential.
Alternative lenders typically have a faster application process, and thus, faster funding than traditional lenders. Some lenders provide same-day or next-day financing. However, this can come at a higher price (more on that later).
Alternative lending vs. alternative credit
While alternative lending and alternative credit are sometimes used interchangeably, they refer to different things.
Alternative credit is a type of credit scoring model that uses alternative data sources to evaluate a borrower’s creditworthiness. It can sometimes also refer to the alternative data sources themselves. For example, if a creditor reports utility bills as tradelines to the credit bureaus, that would count as an alternative credit source.
Alternative lending, on the other hand, refers to non-traditional lending options that provide financing to small businesses. Alternative lenders can use alternative credit in their application decisions, but they don’t have to.
What are examples of alternative lending?
The alternative lending space is quite large, and only continues to grow. Some examples of these types of loans and lenders are:
- Online lenders. These lenders are usually all online, and do not have physical locations. They often use technology to streamline the lending process and offer faster funding than traditional lenders.
- Invoice factoring. This type of lending allows businesses to borrow against outstanding invoices. This product can help free up working capital.
- Crowdfunding. Crowdfunding platforms allow businesses to raise funds from a large number of individuals who each contribute a small amount. Sometimes this is in exchange for first access to a product or equity.
- Merchant cash advance. This type of lending allows businesses to receive financing based on future credit card sales. It tends to come with a relatively high cost of capital.
What alternative lenders look for in an application
This will vary by lender, as each lender will assess a business’s creditworthiness and ability to repay differently. Many alternative lenders take into account similar factors as traditional lenders when assessing loan applications, like:
- Healthy cash flow
- Annual revenue
- Good to excellent credit scores (business and/or personal)
- Satisfactory time in business (often, 1 year or more)
That said, alternative lenders will often look beyond these factors, or have lower eligibility requirements for them. For example, some lenders don’t take into account personal credit, instead lending based on the business’s profile. Others will only look at invoices, and won’t take into account credit scores. Or, the lender may only require 6 months time in business rather than the more standard 1-2 years.
In addition, alternative lenders may use different advanced technology and data analytics to streamline their business lending processes and make quicker lending decisions. Most of these processes are proprietary, and individual to the lender.
What are the pros and cons of alternative loans?
Pros of alternative financing
- Usually have more flexible prerequisites, including lower credit, revenue, and time in business requirements
- Often offer fast funding (many claim 24 hours)
- Can provide a bridge to more traditional financing options
Cons of alternative financing
- Often come with higher interest rates and fees compared to traditional lenders
- Can have shorter repayment terms and require more frequent payments, including daily and weekly payment plans
- Less regulated space can lead to bad actors that engage in predatory lending practices
When shopping around for alternative loans, it’s especially important to know what you’re getting into. Be sure to read up on all the fees as well as the payment cycle so that you know the true cost of capital, and don’t accidentally miss payments.
Last word on alternative lending
Alternative loans can be a valuable financing option for small businesses. When considering alternative loans, it’s important to evaluate the business lender’s reputation, interest rates and fees, funding speed, and loan terms to ensure that you can both afford the loan and that it fits your business needs. By carefully considering these factors and choosing the right lender, you can be on your way to accessing the financing you need to succeed.