4 Reasons Small Businesses Should Avoid Peer-to-Peer Lending

Peer-to-peer lending blasted on the scenes when the Great Recession of 2008 and 2009 made it nearly impossible for small businesses to get loans from banks. Recognizing a need, online marketplaces that hook up businesses with individuals who have money to lend, started popping up all over the Internet. A necessity at first, they became a preference as the nation clawed itself out of the protracted downturn.

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Eight years later, they are still popular, with tons of small businesses scoring loans from the myriad of different online lending services. According to Lending Club, a leader in peer-to-peer (P2P) lending, more than $28.7 billion in loans have been issued on the platform since 2010, with many customers using it to refinance debt.

The company doesn't break out how many went to small businesses, but, with credit cards as a common way to purchase things among upstarts, it's likely that lots of those loans were for tiny enterprises.

However, peer-to-peer lending isn't for everyone. Yes, small businesses can often get a lower interest rate on a loan than at traditional banks. But it's not always a given. Then, there's the underwriting process, the relationship factor, and loan sizes that all come into play when turning to a P2P lender.

Why P2P Lenders Are Not Always the Best Bet for Your Business

1. It's Not Always Cheaper

One of the appeals of P2P loans is that small businesses can get a lower cost of borrowing. But that is only true of borrowers who have the best credit score. For the majority, they are going to pay more than if a bank would have lent them the money to begin with.

According to the Small Business Administration, citing a Federal Reserve working paper, small business borrowers paid an interest rate on P2P loans that was roughly two times higher than at a bank.

Small business loans tend to perform worse than other types of borrowing on these platforms, to the tune of 250 times worse. It's one of the reasons for the higher interest rates. These bad performing loans have started to get the P2P lenders in trouble: Consider Lending Club and OnDeck, two of the small business loans leaders. Both went public in 2014 and have since lost more than 80% of their value. Lending Club's descent has more to do with compliance issues that resulted in the resignation of Chief Executive Renaud Laplanche. OnDeck has faced questions about its growth prospects and default rates. This has led other P2P lenders to rethink their own IPO aspirations.

Why should small business borrowers care? With more scrutiny placed on these lenders, the harder the underwriting process becomes, the greater the chance of paying more in interest. Not to mention that in rare cases, a loan won't get funded because of the platform's viability. Then there are the costs associated with using the service: P2P platforms can tack on as much as a 5% fee, which means less money going to the borrower.

2. A P2P Loan Is Not a Given

Many small businesses spurned by a bank think they can simply log on and get a loan from one of the P2P lenders on the Internet. Even if they have to pay more for it, they assume they will have the cash in hand in a speedy manner no matter what. But P2P lending isn't the wild west, which means these platforms are conducting due diligence on the borrower and underwriting the loan—even though individuals, and not the platform, are doling out the money.

For business owners with a bad FICO score, it means that they aren't going to secure funding.  Businesses with meh credit will pay up for the loan, while those with stellar scores will get the best deal, similarly to how banks operate.

The borrower also has to go through a similar application process, including offering up their credit history, bank statements, and other financial documents to determine if they are creditworthy and the interest rate that they will pay if they are approved. A business owner could go through all of the paces, only to be turned down. Not understanding that can create a lot of disappointment and wasted time, which could be devastating for a small business.

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3. Loan Size Matters

For many businesses, particularly startups and small ones, funding needs are too small to entice bigger investors while big banks simply aren't interested. That is where P2P lenders come in. Traditionally, the loans are smaller in size, which can limit the growth of a small business. This is particularly true of established companies that already have a brand name or are in growth mode. Those eyeing expansion internationally also tend to need more money than what a P2P platform can offer.

Sure, you can get a small amount fast at a decent interest rate, but it may not be the most cost-effective source if you need larger amounts of money shortly thereafter.

Then there is the relationship factor: Business owners who work with a bank usually have an established relationship and, as a result, can get a better deal. That's particularly true of credit unions and regional banks that cater to small and medium-sized businesses. Having that established relationship can go a long way in making borrowing more attractive and can't be overlooked despite the allure of P2P platforms.

4. P2P Borrowing Requires a Level of Trust and Tech Know-How

P2P lenders may make it quick and painless to get loans, but for a lot of small business owners, it's the technology that scares them in the first place. Surveys of business owners, particularly ones on the smaller side, have shown that they are afraid of applying for a loan online, even if it's a P2P.

After all, data breaches are endless these days, with even the best-secured firms getting hit. Small business owners who are afraid of getting their personal information compromised, or ones who aren't tech savvy, may want to find another source of funding.

After all, if you are going to be worried about the what ifs once you have your loan in hand, then it's going to take away from the purpose of getting it to begin with. Not to mention that P2P lenders have been known to shut down, which could mean all your hard work applying for the loan was for naught.

Final Word

Thanks to technology and the reluctance on the part of banks to lend to small businesses after the Great Recession, P2P platforms stepped up, filling a need that traditional financial firms chose not to meet. And while P2P is still hugely popular, lending billions of dollars to all sorts of people, it may not make sense for your business.

Before jumping in, you need to consider your credit score, the amount of money you want to borrow, your existing relationship with your bank, and your tech savviness. Yes, P2P lending is an option for small businesses, but often, not the best one.

About the Author

Deirdre Tenner is known as a finance guru of sorts, with her background of over three decades working for Corporate America before becoming a small and mid-size business consultant. With her thorough knowledge of the business world, she’s helped her clients find the right steps to take, especially when it comes to what kind of loan her client might benefit from most.

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