FinTech SMB Lending: Are interest rates charged to small businesses by FinTechs high compared to rates large banks charge?

Note: The below is my own personal opinion and not the views of any specific company!

The topic of pricing (or interest rates) charged to small businesses ("SMB") for business loans is often a contentious and misunderstood topic. Too often, people not as familiar with the industry cast a bad light on FinTech SMB lending claiming that the rates FinTechs charge to SMBs are high and predatory. While there are some predatory lenders out there, the vast majority of the established digital small business lenders might actually be more inexpensive than what large banks charge small businesses.

As background, I work in business development at a publicly-traded FinTech SMB lender that focuses on providing capital to undeserved small businesses (those that are often turned away from the larger mainstream small business lenders in the space, e.g., Chase, Bank of America, Wells Fargo, etc.). In working in the industry, I often realize that folks are quick to judge SMB lending rates as high when, in all actuality, I believe this is a major misconception that I hope to shed light on in this post!

Let's take a look at factors that drive this misconception and some reasons why loans provided by online small business lenders are actually less expensive than people think.

1. Annual Percentage Rate ("APR"): The incorrect measuring stick for short term loans

Often times, people use APR as the default metric to compare small business loans, whether those loans are long-term oriented (> 2-years) or short-term oriented (< 1 year). While it's good to have an apples to apples comparison of pricing across different tenor types, using APR for short-term loans over inflates the actual outlay of interest dollars a small business has to pay to a lender.

For example, a $50,000 6-month loan with an interest cost of 15% ($7,500 in total interest costs) turns out to be approximately 60% APR. The reason for this is two fold:

1. The numerator of APR is interest paid ($7,500) divided by average outstanding loan amount (This is actually $25,000 and not $50,000). Because loans are paid back throughout the course of the loan term (in this case 6 months), the actual average outstanding balance is approximately half of the initial money lent, so $25,000 instead of $50,000. This dynamic causes the APR to have a doubling effect from the actual interest rate of 15% to an APR of 30%.
2. The denominator of APR uses the term of the loan (in this case 6 months) and annualizes it to one year. Again, this has the effect of doubling the APR once more from 30% to 60%.

For longer-term oriented loans, say 2 years and those that are interest-only for a period, average outstanding balances are closer to the initial loan amounts and the annualizing of interest rates is not necessary since the loan terms are already in annual terms.

To summarize, when you convert interest rates of shorter term loans into APRs, there is a meaningful inflating effect, as opposed to converting interest rates of longer term loans into APRs where this inflating effect is more muted or non-existent.

2. In lending, pricing should be compared on a relative basis (i.e. relative to risk) and not on an absolute one

After looking at several publicly traded money-center banks (e.g. Chase) as well as a couple of publicly traded SMB FinTech Lenders, I found that for riskier small businesses, the average APRs were closer to the 5-10% range. Based on their average loan losses of 50bps, the price to loss ratios (i.e. charge offs) -- a measure of pricing relative to risk -- is an astounding 20x, as compared to many FinTech lenders whose price to loss ratios are in the 3-5x range.

What this hopes to illustrate is that while FinTech lending rates may be higher on an absolute basis, the pricing that FinTechs offer is reflective of the underlying risk of the borrowers that these FinTechs have exposure to.

The natural question then becomes is why on earth are big banks charging so much for customers whose risk is incredibly low?

3. Loans that FinTechs make are typically unsecured so rates are higher than secured consumer loan products

While this situation is not as often encountered, there are instances when folks have "sticker shock" on APRs for unsecured small business loans.

The reality is that FinTechs typically lend to small businesses without any assets/collateral securing the loans. As a result, the interest rates need to be higher to reflect the underlying risk of the businesses.

In addition, people typically anchor interest rates and APRs they're normally used to in their daily lives, such as the rates they pay on their homes and cars and, while it's not bad to compare loan products, these products are fundamentally different.

4. Traditional small business banking operations are very profitable, have unnecessary operating expenses, and actually take in more money than they lend out to small businesses!

If you look at Chase's business bank, it generates over 25% return on equity while spending heavily on branch banking operations, as compared to FinTechs who leverage technology to drive efficiency and are either still unprofitable or have 10-12% returns on equity.

This leads me to one conclusion: Traditional banks not only overprice their loans, but also overspend on manufacturing these loans. These costs are ultimately borne by the small businesses who work with large banks.

The last thing that is probably the most egregious is that many large banks take in 5-6x more in small business deposits than they lend out. In addition, these large banks often offer below-market interest-bearing accounts on these balances, which exacerbates the issue.

The example below shows that Chase took in a whopping $136B in low interest-bearing deposits from small businesses, while only lending out $24B in small business loans (and quite profitably, I might add)! So, let me get that straight: 1) Charge more on low-risk loans 2) Take in more $ and pay nothing on it and 3) Lend way less than you take in, too!

Source: JP Morgan Chase & Co. 2019 Investor Day Presentation

5. When comparing FinTech and traditional bank pricing, factoring in opportunity cost is important

Large brick-and-mortar banks can take up to 8 weeks to underwrite and approve small business loans and, even then, these loans are reserved for those that deposit 5x more than what they want to borrow (see above :D).

More often than not, the smaller businesses (if they are even approved after investing weeks and weeks of time on the application process) are turned away. Because of this underlying opportunity cost of time (and cost of potentially not getting approved), small businesses need to factor in time and probability of approval as two key variables for how they think about relative loan costs.

That said, traditional banks have been becoming more digitally focused and this gap is not as wide as it once was, but still a factor to bake into the overall equation when considering relative small business loan pricing.

In conclusion, instead of conveniently defaulting to the common misconception of believing that digital small business loans are too expensive, I'd challenge those to consider all the above points before forming an opinion. Perhaps it's the big banks that are taking advantage of small businesses and not the other way around.