Cash advance merchants and short-term lenders are a viable alternative source of financing for small businesses that aren't able to acquire a bank loan. They provide a lump sum with a fairly quick payback and are particularly attractive to small business owners with poor credit and little to no collateral. However, the trade off for fast cash with limited underwriting is cause for concern.
These lenders don't want to take risk, so they deal in short term loans and expect the borrowers to start paying the advance or loan back immediately. In many instances, there is just not enough time for the borrower to pay back the loan. What this means for the business owner is steep premiums, high interest rates and a slippery slope into greater debt.
Most business owners don't realize that the minute you cross the 50% mark of your payback, the provider is going to do everything in his or her power to convince you to renew and take on more money.
These lenders rely on this tactic. Once you've shown that you are able to make regular payments on an advance, the provider will want to hook you in and continue to advance you money. They might throw in slightly better terms and slightly lower rates, but the high-cost advance remains the same.
My main issue with this hook is that enticing business owners into renewals is contrary to the exact theory that they promote. If the money borrowed really was a short-term cash advance, then business owners shouldn't have to renew.
By making all attempts to keep a business owner in a short-term loan loop, the provider is potentially blinding the business owner from the possibility of more affordable financing through a bank loan. Cash advances, if they must be taken, should only be a short-term solution and a bridge to better financing. The goal should ultimately be to graduate from cash advances to bank loans that offer lower interest rates and better terms.
At my loan brokerage, we call this process the "path to bankability." That is, graduating from a cash advance or alternative lending program to an FDIC-insured bank loan.
We recently dealt with two cases in our office where two clients were in a cash advance program and were considering renewals. Instead of continuing on the path of high interest rates, short amortization periods and premiums, we were able to get them into a bank loan. We promote this path to bankability with our clients whenever possible, and would encourage all others in the industry to do the same.