This guest post comes to us from Eric Goldschein. Eric is a staff writer at Fundera, a marketplace for small business financial solutions. He covers entrepreneurship, small business trends, finance, and marketing.
Running a small business is stressful enough without worrying that someone will try to take advantage of you in a time of need. Unfortunately, predatory business loans are exactly that: A lender taking advantage of a borrower through unfair or unclear terms and practices.
While small business lending isn’t predatory by nature, there are lenders who structure loans in a way that can cost business owners thousands of extra dollars, if not their entire business.
If you’ve decided that applying for a small business loan is the right decision for your company, it’s crucial that you do your homework and take note of what makes for a good versus bad loan to avoid putting you and your business at risk.Look out for the following warning signs when applying for a loan, and go elsewhere for funding if you come across any of these practices or situations:
Warning Sign 1: Unclear pricing and terms
Any good lender will tell you, in no uncertain terms, what you owe them for the loan and how long you’ll have to pay them back.
The best way to know the true cost of a loan is the APR — annual percentage rate. The APR encompasses the interest rate or factor rate, as well as any other fees you’ll accrue, in the course of taking on the funding.
The APR is a good way to make an apples to apples comparison of two different loan products. If a lender only shows you the interest rate for the loan—or obscures any other information such as the length of the repayment term or what the fees are for a late payment—then they are likely purposely hiding the full cost from you.
Warning Sign 2: Aggressive lender or broker practices
Taking out a loan means taking on debt, with the goal of using the infusion of funds to add value to your business. In a perfect world, it’s a win-win for both the lender and borrower. The lender or broker should do everything in their power to steer businesses towards taking out the financing that best matches their needs and capabilities.
That being said, brokers should not push borrowers into accepting loans they’re not comfortable with or don’t understand. A broker that doesn’t take the time to go over every aspect of the loan—including their own fees or commissions—is likely trying to hide something until it’s too late.
Warning Sign 3: Little to no application process
A class of online lenders has recently emerged, using algorithms and other technology, to more quickly approve, or decline, business loan applications.
No lender, however, should ever say things like “No credit, no problem,” or “Get approved instantly.” Good lenders know that it’s in the best interest of both parties for borrowers to successfully pay off their loans. Therefore, they shouldn’t approve businesses that don’t have a positive business credit history or demonstrated income.
If a lender offers to approve you without asking to see your business and/or personal financials or to examine your business in any meaningful way, be wary.
Warning Sign 4: An offer that is too good to be true
Again: If a lender offers you incredible rates for seemingly no good reason—especially if you are a new business or have poor credit—that’s a red flag.
Even good lenders expect to make a profit off your loan—that’s what they do. Unless the organization you’re dealing with is a nonprofit that disseminates grant money, no financing will be free or close to it. SBA term loans, considered some of the best small business loans available, typically have an interest rate of around 8%. Anything below that—especially from a lender with whom you don’t have a prior relationship with—is suspect. If you have poor credit, a legitimate lender will likely charge you even higher rates.
Warning Sign 5: No physical address or scant web presence
Even in our highly digital era, any reputable business will have a physical address. And no—a P.O. box does not count as a physical address. P.O. boxes offer owners a level of anonymity that reputable lenders don’t need.
Good lenders should also have a robust web presence, including a mobile-optimized website, social media channels, and reviews on sites like Glassdoor. A website without much information is the sign of a business that wants to keep a low profile.
Warning Sign 6: Exorbitant prepayment penalties
A prepayment penalty is when the lender levies a fee on a borrower for paying off their loan early. This helps ensure that lenders receive all the interest fees they expected to get when they underwrote the loan.
Though written prepayment penalties are rare, if they exist they should be clearly stated in your business loan contact. But if your contract references unclear prepayment penalties which may or may not be levied, or an especially high fee, it’s a good idea to steer clear. Around 1% of what you prepaid is considered standard; on the higher end of reasonable fees, SBA loans that carry a prepayment penalty charge you 5%, 3%, then 1% of the amount you prepaid, respectively, for three successive years.
Warning Sign 7: Abnormal payment schedules or structures
Most small business loans have repayment schedules that ask for payments on a monthly basis. Some are repaid weekly or even daily, but the schedule will be consistent. Any irregular payment schedules that don’t show you exactly when payment is due are a sign of trouble.
Additionally, some lenders structure their loans to look enticing at the beginning, only to have payments “balloon” with excessive payments towards the end of the loan. Lenders often use these high payments as a way to encourage borrowers to refinance and take out yet another loan, trapping them in a churn cycle of borrowing.
A good loan will have a consistent schedule of payments that are more or less the same throughout the life of the loan.
Warning Sign 8: Confessions of judgment
Confessions of judgment are legal documents that help lenders enforce debts without having to go to trial. When a borrower signs one, they agree not to submit a defense in a court proceeding against them should they fail to make payments. Confessions of judgment have been outlawed for consumer loans for decades, and are illegal for use in business loans in many states.
New York, however, is one state that allows the use of confessions of judgment. Some predatory lenders have used this obscure law to their advantage, extending financing to businesses across the country with the goal of taking them to court in New York and seizing their assets. According to a recent Bloomberg report, “Cash-advance companies have secured more than 25,000 judgments in New York since 2012… worth an estimated $1.5 billion.”
While confessions of judgment aren’t always used so viciously, it’s a good bet that if a lender asks you to sign one without a corresponding Settlement Agreement that lays out exactly why and when you would be taken to court, the lender could use your COJ to their advantage.
Be alert and read the signs
There is always some risk involved in taking out a small business loan. But the process of doing so should never feel unsafe. You are putting a lot on the line by taking out financing to fund your company—make sure you’re working with reputable lenders who don’t engage in the practices that could break your business.