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Borrowers beware: Fed discovers shady small business loan practices

Peter Miller
The Mortgage Reports contributor

Need a small business loan? Do your research carefully

Small business loans can be a danger zone of the financial marketplace.

While residential mortgage rates hover in the 3% range, commercial lenders often charge 40% and more, according to the Federal Reserve.

How is this possible?

The basic answer is that commercial loans “are not subject to most federal consumer protection laws and regulations,” explains the Federal Deposit Insurance Corporation.

That means it’s up to you, the small business owner, to find a business loan that’s both safe and affordable.

Here are a few ways you can do that.

Should you use a personal loan to cover business expenses?


In this article:


The issue with small business loans

It may seem remarkable, but according to the FDIC, commercial lenders don’t have to show the cost of credit as a dollar amount or as an annual percentage rate (APR). They don’t have to disclose loan terms in a meaningful or uniform way.

Commercial lenders do not have to disclose loan terms in a meaningful or uniform way. It’s the borrower’s responsibility to research and choose a reputable small business lender.

The result of lax regulation is what you would expect. With today’s digital technologies you can get business loans in days if not hours. You can also pay commercial loan rates that are shockingly high, sometimes as much as 80%.

We know this because the Federal Reserve has just published an important business loan study.

The Fed’s study revealed how deceptive lending practices by some small business lenders — not all — can lead to borrowers paying sky-high interest rates on unfavorable terms.

>> Related: Online mortgages vs. online business loans: What’s the difference?

How to protect your interests with business loans

Small business loans are a staple of the commercial marketplace. Entrepreneurs need financing to acquire inventory, fund payrolls, buy property, and more. For new businesses, commercial borrowing is often a practical necessity.

But small business owners also have to be extra vigilant when taking out business loans, especially online.

When borrowing for a business there are several steps you can take to protect your interests.

Compare personal loans for small business use* (Feb 24th, 2020)

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Don’t assume you’re protected from predatory loans

First, understand that commercial lending and non-commercial lending are different. The consumer protections you expect for personal borrowing likely don’t exist when it comes to business loans.

That means you’ll need to be extra scrupulous. Read your loan estimate carefully and make sure you fully understand the terms and long-term costs of the loan.

If you’re unsure, work with a financial professional to find the right loan for you.

Make sure you shop around for business loans

Second, shop around for business loans. Commercial loan rates, fees, and terms vary widely. So even if all lenders used upstanding practices, you’d still have to compare options to find the best deal.

Check my eligibility for a personal loan up to $100k* (Feb 24th, 2020)

*TheMortgageReports and/or our partners are currently unable to service the following states – MA, NV

Keep your goals as a borrower in mind

Third, keep your eye on your goal. For instance, do you really need a loan ultra-fast? Or can you spend a little time looking for one with the lowest rates and fees?

One key indicator is to look at the lender’s language. Are rates and terms clearly posted? Or does the site focus on speed and convenience, like these examples from the Fed report:

  • “Get a quote in minutes”
  • “Minimal paperwork”
  • “All credit scores considered”

Speed doesn’t necessarily equate to high rates. But if a lender solely advertises convenience and doesn’t post rates or terms, that’s probably a red flag.

Consider a term loan for business financing

Fourth, consider a term loan for business financing. Term loans are a basic form of financing and generally offer a fixed interest rate. With a fixed rate, the cost for principal and interest is the same every month. You won’t be surprised with higher rates and/or monthly payments over the life of the loan.

Check with online lenders and banks

Fifth, when speaking with lenders be sure to contact local banks as well as online websites. Although business loans are outside the scope of most regulation, banks themselves are regulated and, as a result, you might find more attractive rates and terms.

Educate yourself on safe small business loans

Sixth,  check out the Fed’s report on business lending practices. Just 36 pages long, it’s “must” reading for business borrowers who want to avoid sky-high interest rates and fees.

Read the Federal Reserve’s report on small business loans here


If you need a small business loan, here’s what to look out for

Commercial loans are inherently different than loans taken out by individual consumers.

Consider shopping for a mortgage, for example.

When you’re looking for a home loan as a buyer, federal law requires each lender to provide you with a written loan estimate. This is a standard form that clearly outlines your rate, fees, and other costs associated with the home loan.

>> Related: How to compare mortgage loan estimates

But for business loans? No such standard form exists.

The Fed study reviewed ten business lender sites and found that four listed no rate or product costs.

The Federal Reserve reviewed ten business lending sites, and found that four did not list rates or product costs.

In addition, loan costs were often impossible to compare. Why? Because there isn’t a standard “business loan language,” and lenders have different names and definitions for each charge.

Look for footnotes and fine print on the advertised loan rate

Loan fees can add up quickly, causing the actual cost of an advertised “low-rate” loan to skyrocket.

But it’s not always easy to identify these fees when researching small business lenders online.

Consider a $50,000 loan. The Fed went to several online sites to compare rates and terms and found a huge difference between the advertised rate and the estimated loan cost.

commercial loan hazards

“In some cases,” said the Federal Reserve, “footnotes and fine print contain information on fees that companies typically charge for their products, aside from interest charges.

“These fees are most often for product origination, but others include administrative fees, account maintenance fees on credit lines, or fees charged by partners.

“Fees may be disclosed as a range of rates, flat monthly or one-time charges, or charges ‘up to’ a set percentage. Some lenders do not describe any fees on their websites.”

Part of the problem is the lack of clear language. What is a “fee rate”? What is a “factor rate”?

Without clear, regulated loan language, it can be hard for business borrowers to understand what the real costs of their loan will be.

Compare personal loans for small business use* (Feb 24th, 2020)

*TheMortgageReports and/or our partners are currently unable to service the following states – MA, NV


Business loan payment plans

If you have a residential mortgage you know the deal with repayment. You make a monthly payment that includes principal and interest and maybe mortgage insurance.

But with a business loan, there could be surprises in your repayment plan — some of them unwelcome.

It’s possible for payments to be required weekly or even daily with business loans.

The Fed describes two types of repayment plans:

Business loans and lines of credit

Some loans are term loans with fixed rates, multi-year terms, and fixed monthly payments.

Term loans are fixed, predictable, and generally safe for borrowers.

“Other products have a less traditional structure,” the Fed continues, “with fixed fees or total repayment amounts, and requiring weekly or daily payments.”

“Equivalent annual percentage rates (APRs) typically range from 10 percent to 80 percent, and funds are often repaid in six to 18 months.”

Merchant cash advances (MCAs)

“MCAs entail the sale of future receivables for a set dollar amount, repaid with a set percentage of the business’s daily sales receipts,” says the Fed.

For example, a $50,000 loan might be provided in exchange for $65,000 in future receipts. This could be repaid with automatic draws of 10 percent of daily credit card sales.

“Depending on the speed of repayment, equivalent APRs may exceed 80 percent or even rise to triple digits. MCAs are generally repaid in three to 18 months.”

Merchant cash advances can be expensive and unpredictable, as payments can vary based on daily sales.

Business loan prepayment penalties

Let’s consider residential mortgages as an example again. With most mortgages, there is often no prepayment penalty. That means borrowers can pay off the loan early without repercussions. And when there is a penalty, the amount is limited by law.

For business loans, terms surrounding prepayment penalties can be foggy, unclear, and still perfectly lawful.

For instance, the Fed found that with some business loans, prepaying the debt did not reduce loan costs at all. Once the loan is originated the borrower is on the hook for all principal, interest, fees, and charges.

Prepaying with such loan terms actually increases the interest rate. This happens because the borrower is being charged interest for debt that has already been paid off.

This is just one example of how unclear loan terms can leave small business borrowers on the hook for much higher payments than expected.

It’s crucial to read and fully understand your loan terms. If they’re unclear, look over the documentation with an expert before signing.


Alternative small business loan options

Bank loans vs. online business loans

Banks face regulation at the state and federal level and yet when it comes to business loans familiar standards often do not apply.

The Fed looked at five online bank sites and found that “three of the five banks provided cost information for their credit products [and] two provided none.

“Among the three [lenders] that did give more thorough product information,” says the Federal Reserve, “the products tended to be traditional term loans with fixed monthly payments and were described using familiar terminology.”

In other words: The lenders that were more forthcoming with loan information tended to have more consumer-friendly rates and terms.

Consider personal financing instead of a business loan

For many business owners, the best option may be to supply business capital with personal financing.

In other words, if you have real estate equity you might want to get cash with a home equity line of credit (HELOC), second mortgage, or a cash-out refinance.

For small amounts, look into personal loans from banks, friends, and family.

Compare loan rates today

Interest rates are low right now across the board. Whether you need a small business loan or a personal loan to finance business needs, there’s a good chance you’ll be able to find affordable financing.

Start shopping and find out what rates you’re eligible for using the link below.

Check my eligibility for a personal loan up to $100k * (Feb 24th, 2020)

*TheMortgageReports and/or our partners are currently unable to service the following states – MA, NV