An Introduction to Alternative Lending
Bank loans are the traditional method to finance business projects and ventures. Banks usually perform credit checks or ask for collateral, but loan approval isn't guaranteed. As a result, many borrowers can struggle to obtain a loan, despite fulfilling these requirements.
It can be challenging to qualify for traditional loans, but banks aren’t the only sources of funding as the alternative lending industry continues to grow. Application and approval processes for these loans are relatively faster and more convenient through the use of machine learning. Alternative lenders also assess risk differently when determining an applicant’s eligibility, which may offer more funding options to borrowers.
Let’s dig deeper into alternative financing, how it is different from traditional financing sources, and its pros and cons.
What is Alternative Financing?
Alternative financing is funding that is obtained from a source other than a banking institution. Alternative lenders are usually online-based private lenders that may offer more flexibility and accessibility than banks. For example, some of them allow fast access to funding and provide flexible repayment schedules. However, please note that even though these funding options are less strict towards borrowers, they don't fully guarantee approval either.
As opposed to traditional loans, alternative financing offers a wider variety of funding options to apply for. These are the most common ones:
- Term loans - are similar to a traditional loan but are obtained through private lenders rather than banks. Term loans come with a set repayment period and have fixed or variable interest rates.
- Lines of credit - are a convenient funding option for small businesses. The borrower receives a sum of money that they can withdraw at any time. The interest is applied only to the funds that have actually been withdrawn.
- Invoice financing - allows businesses to sell outstanding invoices. The lending company purchases the business’s unpaid invoices and collects the receivables directly from the customers.
- Merchant cash advances - are a lump sum payment provided by a lender. Upon approval, businesses are free to spend it on whatever they want. The creditor recoups the principal amount and the interest by drawing a fixed percentage from your future credit card transactions.
- Equipment financing - are special loans for purchasing long-term assets, such as computers and machinery for your business.
- Equipment leasing - are similar to equipment financing, but the equipment is given to the borrower only for a fixed time. In most cases, machinery and equipment need constant maintenance. Maintenance can cost the business a lot of money, so they may choose to lease it for a couple of years instead.
- SBA loans - are designed for small businesses and provided by the U.S. government’s Small Business Administration program. The SBA does not issue the loan themselves. Instead, they give the government’s guarantee to regular commercial bank loans. This means that the government can repay up to 85% of the loan amount if the borrower defaults.
- Microloans - are a type of financing offered to minorities and underserved demographics. These can be based on gender, race, ethnicity, disability, or income level.
- Crowdfunding - is funding from different donors. Websites such as Kickstarter and GoFundMe offer an online platform for individuals and businesses to conduct fundraising. Crowdfunding is typically donation-based and does not require the borrower to repay the amount gathered.
- Business grants - are awarded by the government or nonprofits to facilitate business activity. They usually accept applications from certain types of businesses and grant loans to those that meet their requirements.
Understanding Fintech
Fintech (financial technology) refers to the use of technology to deliver financial services. It was initially created to automate processes at the back-end of financial institutions. However, with the emergence of online businesses, fintech has taken a more customer-oriented shift. As a result, it now acts as a driving force for many industries, among which is alternative financing.
There are numerous services currently available through fintech. You can transfer money, pay your bills, track your investments, and even borrow money without going through a bank. Even though banks are gradually embracing fintech, there's a significant difference in how they operate and deliver value compared to alternative lending companies.
How It's Different
Fintech and traditional banks operate in pretty different ways. To understand the main differences, we can look at four main categories.
- Business operations. Fintech is oriented toward innovation, accessibility, and speed. It uses new technologies like artificial intelligence and machine learning to accelerate verification processes and conduct accurate risk assessment. Also, since many fintech companies primarily operate online, they can offer more flexibility.
- Customer experience. Alternative lending companies usually do not require the applicant's presence, and the approval process may be much shorter. Banks typically require the applicant to be physically present to open accounts and request financial services. Moreover, banks also have fixed hours of operation. Conversely, fintech companies offer 24/7 online services.
- Regulations. Banks are regulated by specific guidelines and rules like minimum reserve requirements. Fintech organizations may not have to follow as many rules. Without these regulations, they may operate and make business changes at their discretion.
- Growth potential. Traditional banks are still where most of the world's money is kept. Nowadays, they are moving towards a more digital environment to keep up with the recent trends and maintain relevance. On the other hand, the pandemic helped the fintech industry escalate. It is expected to grow at a 23.41% compound annual rate from 2021 to 2026.
Comparing Risk Assessment Models
Alternative lending solutions are different from banks in their approach to assessing risk. Unlike banks, which still follow traditional assessment models, alternative lenders have adopted more lenient policies about determining default risks. As a result, alternative lenders may offer more options for applicants with lower credit scores.
That said, let’s have a deeper look at the evolution of risk assessment methods and what to expect in the future.
Popular Indexes
Due to less stability and consistency of businesses, especially after the COVID-19 pandemic, lenders have started to shift their primary focus away from credit scores and other traditional assessment methods. Instead, they have begun considering other indexes for evaluating a potential borrower's creditworthiness.
One index that alternative lenders may look at is the business stability index. This index gives insight into the applicant's industry and its stability. For instance, the tourism and e-commerce industries have been impacted by the pandemic. As a result, activity in those industries has declined, leading to a lower business stability index. Therefore, applicants whose earnings primarily come from those industries may be considered risky to lend to.
Moving Away from Credit Score
Although credit scores play a fundamental role in risk assessment, they can still fail to provide an accurate or well-rounded assessment of applicants’ eligibility.
Due to the pandemic, many individuals became more reliant on government assistance and relief. Many people used government relief to pay existing loans, which artificially decreased their debt-to-income ratio and increased credit scores. As a result, these credit scores did not reflect the real financial situation of the individual. Due to this occurrence, many lenders turned to alternatives for estimating risk.
As a result, real-time income levels are also being considered for short-term loans. If the applicant has a steady income, they may be more likely to repay a short-term loan on time. Therefore, the lender may consider an applicant’s current income level more heavily than an older negative credit rating.
A Faster Process
In some cases, applicants may need to expedite the loan process. However, it can take a long time for banks to evaluate a candidate's profile, at times even a couple of months. In addition to the lengthy verification process, the applicant may still get the news of rejection. Even if the applicant does receive approval, banks do not usually disburse the funds in one lump sum.
Alternative lending systems are designed to make the application process relatively faster and smoother. With a simpler online request structure, alternative lending companies typically come with less paperwork and quicker decision-making. As a result, some applicants may receive approval and funding much quicker.
New Advances in Technology
Fintech is constantly implementing new technologies to help deliver seamless financial services to customers. Technologies that have transformed the lending industry include artificial intelligence, machine learning, and even blockchain.
Many alternative lending companies incorporate unique artificial intelligence and blockchain systems to accelerate and protect various customer touchpoints. For example, artificial intelligence models can improve the loan request process by analyzing data and providing less biased results. Additionally, more lending companies use artificial intelligence algorithms to calculate default risk with more accuracy. As a result, better prediction models may quickly and efficiently help lenders determine which borrowers would be the best candidates for a loan.
Moreover, blockchain technology allows lenders to reduce the loan processing time and offer relatively flexible and competitive financing offers. Alternative lenders who utilize blockchain rely less on third-party intermediaries, which can reduce costs and time of obtaining a loan. Blockchain also helps lenders and borrowers establish fair loan conditions and protect sensitive information via smart contracts.
Additionally, artificial intelligence and machine learning are being utilized in apps specializing in autonomous finance. Autonomous finance is a tool that assists borrowers in making financial decisions and managing their money by developing personalized action plans. Autonomous finance may maximize individual financial performance by understanding customers’ goals, spending habits, and financial comfort levels.
Buy Now, Pay Later
By now, pay later (BNPL) is a short-term financing option that allows customers to purchase something and make a payment later. Many companies have incorporated this model into their checkout interface to simplify and speed up the process.
Generally, every company that offers buy now, pay later financing has its own terms and conditions. However, this is what the process typically looks like:
- Before purchasing from a seller, you choose the buy now, pay a later method, if available.
- Once your request is approved (which usually takes a couple of seconds), you pay approximately a 25% down payment.
- You start making timely payments in the future.
When you make a payment with a credit card, you usually pay the minimum every month along with the interest and other fees. With the BNPL method, you receive a fixed schedule of payments with interest. A credit check will likely be performed when applying for BNPL.
Pros of Alternative Financing
After exploring the world of alternative financing, we can draw conclusions about its strengths and weaknesses. Based on the information previously provided, these are the main advantages of alternative loan services:
- Availability of multiple funding types.
- Relatively easier application process and less paperwork.
- Relatively faster decision-making.
- Relatively higher approval rate (According to Biz2Credit.com: 56% for alternative lending and 26% for traditional banks)
- Tailor-made loans for small and medium-sized businesses
- Less emphasis on credit score
- Lower minimum revenue requirements
- Minimum or no restrictions on how you use your funds
Disadvantages
Alternative financing can be an attractive option for many businesses and individuals. However, it also comes with its drawbacks. We highlight the following four:
- Relatively higher interest rates
- The maximum loan amount is usually lower
- Repayment times may be more frequent
- Loans may have shorter terms
All perks aside, alternative lending comes at a much higher risk for the lenders. Because of this, these loans typically have higher interest rates than banks. The factor of risk can also prevent lenders from providing large amounts to applicants. As a result, the alternative loans market can be a handier option for small and medium-sized loans. However, it may not be the best choice for borrowers opting for large-sum financing.
Sum Up
Many borrowers have started to move away from traditional banks to seek relatively quicker and more efficient financing elsewhere. Alternative financing institutions may offer borrowers more funding options with competitive rates and flexible repayment options. Alternative lenders also employ cutting-edge technology to assess risk differently and potentially provide more loans with more accuracy.
Rather than traditional loans that rely heavily on credit scores, alternative lenders may consider income level and stability indexes to determine an applicant’s eligibility. Additionally, with the help of artificial intelligence and machine learning, alternative lenders can more accurately estimate and calculate default risk.
Buy now, pay later is also an alternative short-term financing option that allows borrowers to purchase on the spot and make interest-free payments later. Although alternative lenders may offer quicker financing options, there are downsides to consider, as well. For instance, alternative lenders usually offer lower loan amounts with higher interest rates and more frequent repayment periods.
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