A public relations firm emailed me the other day to ask whether I’d be interested in speaking to the founder of an alternative finance company startup that makes online loans to high-risk borrowers.
These are borrowers who’ve been turned down by their banks because they’ve had credit hiccups or irregular income streams (such as for those who are self-employed), or for other reasons. The startup that contacted me proposes to look past these problems with the help of a nifty algorithm and, of course, millions of dollars’ worth of venture capital.
It joins a number of fledgling enterprises that are eagerly leaping probability formula-first into the deep end of the online-lending pool for the same reason: Consumers and small businesses with less-than-perfect credit represent a large and underserved (read: lucrative) demographic.
Alternative lenders have long enjoyed a presence in the financial marketplace, and not just because banks have a reputation for quickly pivoting between easy- and tough-to-get credit when the economic tide turns. The best of these also move with an alacrity that traditional lenders are unable to match.
The challenge for these companies, however, has always been the price they pay to fund the loans they make.
Banks enjoy access to the least expensive debt capital of any U.S. entity. All those checking accounts that pay pennies on thousands of dollars’ worth of average daily balances? That money is used to make loans at substantially higher rates. But not as high as those charged by the nonbanks.
A portion of the rationale for that is their aforementioned higher funding costs—money that comes from Wall Street and, at times, even from the bricks-and-mortar banks they outwit. The rest is, well, because they can, particularly when a less-than-perfect borrower needs a quick approval.
As important the role that alternative-finance companies play in our fickle financial markets, there a few things that trouble me about this latest crop of ventures in particular.
That technology has advanced to the point where so much of what used to be done more slowly by hand can now be accomplished within nanoseconds online deserves to be celebrated. But does it also deserve to be blindly trusted to make the correct decision when credit is nuanced?
Borrowers with troublesome histories should have their applications more closely scrutinized. After all, the last thing a sinking ship needs is more water. Lenders that operate responsibly should also want to exercise extra caution, not least because investors and funding sources can become tough to deal with when losses mount.
Therefore, the question that nags me most is this: Are these companies in it for the long haul, or are they more interested in booking as many loans as fast as they can in this benign (low delinquencies and defaults) environment in the hope of scoring a big payday via an IPO or a sale to a larger entity?
This isn’t a hypothetical inquiry. Some years ago, I acquired a finance company. When it came time to raise additional investment capital to support its strong growth, the question I was most often asked by Wall Streeters was, “How fast can you double or triple your volume?” (Coincidentally, this is a concern that’s also being echoed by the Office of the Comptroller of the Currency with regard to the apparent relaxation of banks’ credit-underwriting standards in the quest to compete with these and other lenders.)
So with all that in mind, borrowers who contemplate doing more than one deal with a high-speed/high-rate lending machine would do well to also ponder these three questions.
1. Can I afford the price? Ease and convenience aside, the higher cost of these loans has the potential to undermine longer-term financial stability and security, particularly when this mode of financing becomes the go-to source for stop-gap needs.
2. Can I live with the terms? As I’ve written before, no contractual provision is more important than the so-called default clause. That’s where you’ll learn what constitutes a breach of contract, the steps you can take to cure it and what’ll happen if you don’t. Whether or not the firm that originates your loan continues to own and/or administer it, the terms and conditions that you agree to upfront will govern both parties’ actions for the loan’s duration.
3. Do I have an alternative? Don’t put all your eggs in one basket. The relationship you establish with one company shouldn’t dissuade you from also cultivating ones with its competitors. Just in case.
This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.
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