Not long ago, one mistake was all it took to dash your business dreams. A missed payment increased utilization of credit, or a single instance of fraud could all tank your credit score.
Once your number got into the 600s, banks started slamming their doors. And in the aftermath of the Royal Commission’s report, even those with scores in the low 700s are having a hard time finding loans.
Think your business aspirations are done? Chin up – new fintech startups like Prospa are ushering in a new era. Whilst your score still matters, it’s no longer the sole determinant of creditworthiness.
In today’s blog, we’ll explore how private lenders are re-evaluating risk, and what that means for you.
From Babylon to America: a brief history of credit
Ever since the days of the Babylonians, lenders have extended credit to borrowers. Doing so allowed this ancient Middle Eastern city to become one of the world’s wealthiest city-states.
When we’ve moved away from this arrangement, we’ve suffered for it. For instance, the banishment of usury during the Dark Ages ground development, discovery, and economic growth to a near-halt. Isn’t it funny that when lenders can’t make a profit, they put their wallets away?
The ban on usury was reversed starting in the 14th century after explorers petitioned for more liberal lending laws. These rulers granted their wishes, kicking off the Age of Discovery.
Even still, only a select few had access to funds. That started to change in the 19th century, as the first credit bureaus began to gather statistics on the creditworthiness of citizens. This move created the infrastructure that would allow them to monitor millions of consumers in future generations.
Out of that came standardized credit scores. In 1989, the FICO score made its debut in America. It weighed numerous factors, with payment history, credit utilization, and credit history length being the three most important.
A chill has descended over the Australian credit market
As well-meaning as this metric is, its weighing creates problems for responsible borrowers sideswiped by tough times. Over the past few years, Australia has experienced its slowest growth in a generation. Declining demand for raw materials from China has sent ripples through the economy.
This uncertainty further cooled a housing market already suffering from affordability issues. And, as if that wasn’t enough, the Royal Commission exposed improprieties in mortgage lending. This bombshell led to the imposition of a stress test, sending the market into a tailspin.
What does all this have to do with credit scores? Until recently, home equity was a major source of collateral. Sharp home price declines (more than 14% peak-to-trough in Sydney) are still fresh in everyone’s mind. Given the uncertainty currently surrounding the Australian housing market, banks aren’t in the mood to accept home equity as security.
This situation has hammered small business owners. Many have struggled to pay employees and rent, never mind suppliers, utilities, and other bills. Others have maxed out their lines of credit. Both actions have tanked the credit scores of THOUSANDS of Australians.
The Big Four, who are reeling from the Royal Commission’s final report, have tightened up their lending practices. Faced with insolvency, entrepreneurs cut off from bank loans were desperate for sources of alternative financing. Fortunately, a white knight has come to their rescue.
The internet has introduced competition to Australian lending
Even before our economy’s recent trials and tribulations, Australian entrepreneurs had alternatives to the financial establishment. Capify first turned on their lights in 2008. Prospa started lending in 2014. They and many others have used the internet to disrupt Australia’s lending industry.
Firms operating in this manner lack the overhead of banks and other legacy firms, giving them an advantage. That isn’t all, though: The internet doesn’t just offer firms cost savings – it also makes them easier to reach. All a loan seeker needs to do is search for something like “small business loans Australia.” Once they do, they’ll have a list of private lenders to choose from.
All this sounds interesting, but how does this affect the average business owner? Let’s say you own a bakery that’s fallen on hard times. With consumer spending on the decline, you’ve run into cash flow problems. At this rate, you’ll need a loan to cover payroll, as you’ve run out of room on your line of credit.
Sadly, your bank just turned down your loan application. Others haven’t replied, and it’s been a week. By month-end, you’ll need to pay rent and bills. Next week, payroll is due.
With plan A in tatters, you’re Googling furiously in search of a solution. After searching “business loans Melbourne,” you come across a listing for Lumi. As a lender that caters to borrowers with less-than-perfect credit, they check all your boxes. You submit your application, and within 48 hours, you hear back. You’re approved with a clear repayment schedule – crisis averted.
And so, the banks surrender yet another loyal customer to the private lending industry. This trend has only accelerated in recent years – in 2018, non-bank lenders collectively experienced 13% YoY growth. At the same time, the market share of the Big Four shrunk by 5.5% YoY.
And, it’s only going to get worse. To date, private lenders have only picked the lowest hanging fruit – obviously-qualified borrowers denied by overly-conservative banks. In the coming years, private lenders are set to get more aggressive as they debut new risk evaluation tools.
New risk algorithms are transforming private lending
Banks by their very nature are risk-averse entities. Most financial institutions prefer secured loans, as collateral assures they’ll get their money back.
Online lenders are different – their founders often embrace the “fail forward fast” ethos promoted by tech startups. Rather than avoid all risk, they make calculated bets using conclusions reached via Big Data analysis.
Still, how can they do this? After all, if a business maxes out their credit, and they haven’t saved for a rainy day, aren’t these signs of financial irresponsibility? In some cases, yes. Overall, though, this conclusion is an oversimplification that misses the big picture.
For instance, nobody could have predicted the rash actions taken in the wake of the Royal Commission. If you have consistent revenues, why should you be denied funding? The fact you lack $200,000 in the collateral shouldn’t necessarily be a hindrance.
Similarly, if the local mine goes on strike for two months, and your restaurant falls behind on the rent, are you a poor credit risk? If a business is brisk the rest of the time, why should you be denied a loan? Bad times don’t last forever, so why should a black swan event tarnish the image of a legitimate enterprise?
Most private lenders agree. In their algorithms, they account for metrics other than your credit score. For instance, in America, a fintech startup known as Fundbox utilizes machine learning to better evaluate credit risk.
It does this by analyzing the accounting books of businesses applying for loans. After crunching the numbers, the AI renders a decision. If the applicant is successful, it also assigns a line of credit based on their finances.
Some online lenders are filling long-ignored gaps in the marketplace
What about micro-businesses, like freelancers, solopreneurs, and family operations? For years, lenders ignored these players. Left to their own devices, they had to get second mortgages, beg family for money, or seek crowdfunding.
Often, though, they had to give up on their dreams. However, ever since private lenders rose to prominence, firms like Max Funding have given the self-employed access to liquidity.
How do they manage the risk that comes with lending to these individuals? To protect themselves against bad loans, they (and most other private firms) limit loans to 4x monthly sales. That way, borrowers can pay off their loans more quickly. Meanwhile, lenders avoid heavy losses, should a default occur.
Other lenders offer loan payback on a “per sale” basis
Remember our mining town restauranteur a few sections back? Whilst we shouldn’t necessarily judge them as poor credit risk, lenders still worry about getting paid. Thankfully, some firms understand the feast and famine cycles common to sectors like hospitality.
Recently, these lenders came up with an innovative solution. Rather than require a regular monthly payment, they instead take a portion of every sale. Consequently, the amount paid is proportionately higher in peak season and smaller in the low season. And, if the economy dives – no worries! The lender still gets paid (albeit slower), and the borrower remains solvent – everyone wins!
Don’t let a number hold you back
There’s no doubt about it – the Australian economy is in a tough place right now. Banks are fiercely protecting shareholder value by not lending a red cent to anyone but elite borrowers. So, if the banks have turned you away, don’t take it personally.
You don’t have to let your expansion plans die an unceremonious death, though. Thanks to the meteoric growth of the private lending industry, your less-than-perfect credit score is no longer an impediment.
If your businesses’ financials are healthy, you stand an excellent chance of getting an unsecured loan. 2020 is going to be a breakout year for countless companies – resolve to be among them!