The Federal Reserve recently published a report about small business lending: Browsing to Borrow: “Mom & Pop” Small Business Perspectives on Online Lenders This lending publication examines perceptions of a select group of small business owners about online lenders, as well as their understanding and interpretation of the information online lenders use to describe credit products. This is a hot topic, as online lenders are becoming mainstream alternative providers of financing to small businesses. Below are a few takeaways from the report.
Federal Reserve SMB Lending: About the Participants
First and foremost, since this was such a small group (42 participants total), the objective of the study was not to come to any specific conclusions — but to surface any key issues that could guide future research, improvements, data collection and policy analysis.
To define the participants further, “Mom & Pop” businesses have at least one but no more than 20 employees and make less than $2 million in revenue. These businesses represent a range of industries in the United States, and all of the participants had sought credit for their businesses in the prior 12 months.
Many of the participants in this study voiced challenges we often hear from small businesses:
- Managing cash flow
- Making payroll
- Collecting payment from customers timely manner
- Finding/retaining staff and managing employees
- Generating new business while continuing to meet client expectations
Online Lenders vs. Traditional Lenders
When a small business applies for a loan from an online lender, the lenders make their decision using traditional metrics (like a business or personal credit score) in addition to other business metrics, such as credit card sales and shipping data. Low credit scores are not necessarily a barrier when it comes to online lending, but the business needs to demonstrate that their revenues are sufficient. This helps online lenders reach under-served borrowers who might not otherwise get approvals, and can make online lenders more appealing to small business owners trying to secure a loan.
However, in this study, participants overwhelmingly preferred traditional financial institutions to online lenders, personal connections or using credit cards — even if the online lenders catered to small businesses. If the participant did use an online lender, their typical response was that online lenders are more flexible with their approval process, compared to traditional banks that are unwilling to take a risk on small businesses.
SMB Lending Publication Key Takeaways
There was one overwhelming trend in this report: The more information online lender websites included, the more appealing and credible they seemed to participants. These business owners wanted to read about product terms, interest rates, overall costs of credit and repayment arrangements — and they wanted this all before they had to give out their information. Some additional noteworthy takeaways:
- While some participants had positive views of online lenders, more than half had negative initial impressions of the industry as a whole. The negative impressions seemed to be based on sales calls from lenders or brokers, as well as continuous emails and direct mail. Many felt they were being “spammed.”
- Participants preferred websites with detailed product information. When reviewing online lender websites, they preferred a website that offered the most detailed information on products, costs and borrower qualifications.
- Participants were most skeptical of websites that provided limited information, especially those that withheld product details until visitors entered their business and contact information.
- When presented with three sample online products, participants found the descriptions difficult to understand or lacking detail about costs and features. However, participants responded positively to a sample disclosure table clearly displaying interest rate, payment amount, fees and other product terms. Nearly all said this level of detail should be available to potential borrowers before they apply and turn their businesses’ financial data over to the lenders, even if it’s just presented as an estimate or potential range.
In relation to these disclosures, it’s important to note that credit extended for a business or commercial purpose is not covered by the federal Truth in Lending Act, which requires lenders to clearly disclose lending terms and costs to borrowers. This is why online lenders can all use different verbiage about loans (for example, terms such as “cents on the dollar”). Loans can also be repaid using various terms. For example, some of these loans can be paid back weekly or even daily. In general, there’s a lack of consistency since the industry is not as regulated as a traditional bank.
Better Disclosures Establish Better Trust
Among most participants, initial perceptions of online lenders tended to be negative. However, after reviewing a few online lender websites in greater detail, some of their negative mindsets shifted. In general, though, participants found it challenging to identify interest rates or estimate costs in any of the examples they were reviewing.
Moving forward, this study indicates a need to identify “best practices” around designing disclosures that include sufficient (but not overly complex) details. The format needs to be easy-to-digest and visually appealing.
Small business owners seemed to appreciate disclosures that mirror those of consumer credit products, since they often rely on personal credit to run their business as well. The study recommended continuous testing with controlled experiments, as these have been shown to significantly improve the effectiveness of financial disclosures like this.
Interestingly, among participants were who approved by an online lender, 52% were dissatisfied because of high interest rates. This indicates that these applicants did not fully understand the disclosures shared with them.
Indeed, many of the small business owners who participated in this study expressed a need for clear disclosure of product costs and terms. If disclosures improved, online lenders could further establish trust and increase their customer base.
The study also recommended that financial technology aim to support the small business market by developing cost calculators, prepayment scenarios and product comparisons tailored to the specific situation of interested borrowers. Across the board, participants are looking for clearer product descriptions, familiar terminology, and understandable figures for interest rates, total cost and repayment amounts.
It’s important for a small business owner who is interested in securing financing to conduct research and make sure any provider is the right one of their business. The online lending industry will gain valuable knowledge by continuing these studies of consumer needs, in service of improving their practices to help small businesses thrive and grow.
