Alternative Lending: What Is It and When Does It Make Sense?

Alternative lending is business financing options outside of traditional banks.
Jun 27, 2017

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You don’t have to walk into your local bank to a get a small-business loan these days. Alternative lending options are just a few computer keystrokes away.

But alternative business loans can be complicated and confusing, even risky. They’re not for everyone.

So when does alternative lending makes sense — or not make sense — for your business? And if it is right for you, what are your options?

We take a look at when and when not to seek alternative business funding and provide choices based on your needs.

When alternative lending makes sense

When you can't get a bank loan

Alternative lending took off in the wake of the 2008 financial crisis, when banks pulled back dramatically from issuing small-business loans. Online lenders stepped in to fill the void, creating Web-based platforms that could quickly process loan applications, providing relief for small-business owners turned away by banks.

Technology was a key factor in this development, as it allowed new players to swiftly evaluate the creditworthiness of borrowers. Online lenders use different types of data — bank statements, tax returns, online accounting sites and even social media accounts — to analyze potential borrowers' personal and business finances.

There are four main kinds of alternative or online financing:

  • A term loan is a lump sum you borrow and repay in about four or five years based on set terms, including the annual percentage rate. This is generally the least expensive type of financing.

  • A line of credit gives you access to a set amount of cash that you tap when necessary. This is generally used by businesses that need short-term financing to bridge cash-flow gaps.

  • Invoice factoring, also known as invoice financing or accounts receivable financing, is an option for small businesses that deal with unpaid invoices. Instead of waiting to be paid, you can get an advance on those invoices, which you then pay back along with a fee when your customers settle their accounts.

  • Merchant cash advances offer a way to get an advance on future credit card or debit card sales. They’re easy to get, but think twice about applying because merchant cash advances are typically very expensive. The APR can range from 70% to 350%.

Banks still offer the best deals, especially federally guaranteed U.S. Small Business Administration loans. But those are usually tough to get — especially if your personal credit is less than stellar. You'll deal with stringent requirements and a long wait.

When you need quick cash

Alternative lending offers a way to deal with a pressing business need or an emergency. If your plumbing goes out or you suddenly run out of supplies, you can’t really wait weeks, or even days, to fix the problem. Quick access to capital allows you to deal with the problem immediately.

With bank loans, especially financing backed by the SBA, you must submit a long list of documents, including business leases and a detailed financial history. Many online lenders require fewer documents, and their main focus often is whether you have the cash flow to make the payments.

In addition, you can get funds from alternative lenders within days — with same-day business loans sometimes an option— and the requirements are typically easier to meet.

Alternative lenders also provide longer-term loans to invest in growth, such as opening a new store or hiring more workers. Again, in exchange for quicker and easier access, your borrowing costs are likely to be higher.

When alternative lending doesn't make sense

When you want low rates

Getting quick and easy financing has a price. Online lenders generally charge a higher APR, which is the true cost of the loan, including all fees.

A few online lenders offer APRs in the single digits, but you need excellent personal credit and a profitable, growing business to qualify for them.

Most alternative business lenders offer loans with double-digit, even triple-digit, rates.

Why? One reason is that most online lenders also require shorter loan terms, which mean higher regular payments.

Also, the borrowers these lenders encounter tend to be those that traditional banks deemed too risky to lend to. In setting higher rates, alternative lenders are baking in the higher likelihood that they're not going to get paid back.

To add to your pain, most online lenders get their funding from capital markets, where investors want a high return for their money. That means the lenders set even higher interest rates so their loans will be profitable.

Find and compare small-business loans

Explore small-business loans to meet your needs and goals with the help of NerdWallet’s comparison tool. We gauged lender trustworthiness and user experience, among other factors, and made recommendations based on categories including your revenue and how long you’ve been in business.