Why APR Alone Isn’t the Answer In Small Business Lending

Curious about how small businesses understand and evaluate the cost of capital, and whether presenting that cost in different ways would affect their choices, Lendio sponsored a survey of a random sample of SMBs across the United States. Our survey found that how the cost of capital is presented has a significant effect on the borrower’s decision making – even though the actual cost of capital was mathematically equivalent. We also discovered a clear preference for “total payback amount” as a way to disclose the cost of capital, rather than APR. As an industry, we should be listening to what small business owners are telling us.

The context for our survey is that the small business lending industry in the U.S. is at an interesting inflection point. During the recession following the crash of 2008, small business lending declined abruptly, leaving thousands of business owners scrambling for the capital they needed. The alternative lenders who filled the void were initially lauded for enabling thousands of small businesses to survive and grow – but as stories emerged of business owners overwhelmed by high cost loan products they didn’t understand, industry participants began to focus on transparency and disclosure.

These discussions often focused around choosing a single, common metric that would allegedly allow small business owners to compare the cost of different loan products quickly and easily. On the consumer credit side, Annual Percentage Rate (APR) has been the standard since the Truth in Lending Act (TILA) was passed in 1968, and not surprisingly, it’s often suggested as the “go to” metric for small business loans as well. After all, proponents argue, small business borrowers are already familiar with APR because that’s how personal financial products such as credit cards, auto loans, and mortgages are disclosed.

We were skeptical about the “apples to apples” comparison because APR may not give business owners a realistic picture of cost for loan products with terms shorter than a year. To put it another way, a bridge loan to get you through a few tough months is a really different product from a long-term financing option for heavy equipment, whose costs are amortized over time. Having worked with hundreds of small business owners over the years, we’d found them savvy, informed, and pressed for time – so we really wanted to know what would be most helpful for them. Here’s what we learned.

Respondents were presented with this scenario:

“Your small business has an opportunity to permanently increase monthly revenue by $5,000, but you’ll need a $20,000 loan to capitalize on the opportunity. Based on your business financials, collateral, and credit score, you were only approved for one term loan.”

These questions were then presented in random order, using APRs of 12%, 36%, and over 100%:

  • As an APR
  • As a factor rate (i.e., $1.XX for every dollar borrowed)
  • As a total payback amount ($20,000+ for the $20,000 borrowed)

The available answer choices were

  • I would take the loan
  • I would forego the opportunity

While we’ve heard a lot of concern expressed that small businesses don’t understand the loan options they’re choosing, what we saw was reassuring: small business borrowers told us that they are more likely to take a lower cost loan, no matter how that cost is disclosed (obviously). Nevertheless, it’s interesting that at all price points , borrowers were least likely to take the loan when the cost of capital was expressed as APR.

Then, we asked an additional question: “ When considering the cost of the loan, the details can be presented in many different formats. From the list below, which format is the easiest for you to understand?”

The results? Two-thirds (over 65%) of borrowers preferred total payback amount.

These survey results tell us how the cost of capital is expressed has a dramatic impact on whether or not the borrower takes a loan. I thought it was especially interesting that small businesses are less likely to take a loan when the cost of the loan is expressed as an APR (vs. a factor rate or total payback amount) even when that loan might be accretive to their financial success.

Fortunately, key industry players are starting to take notice. In response to this data and other feedback received, a group of key lenders have announced an initiative to create a standard format to express cost of capital that includesboth the total payback amount and APR — the SMART Box ( Straightforward Metrics Around Rate and Total Cost) .

The results convinced me more than ever that a single metric is not just over-simplifying – it could actually lead small business owners to make poor decisions. Let’s not make APR a “third rail” for lenders. Instead, as an industry let’s come together and commit to providing small business owners ALL relevant information they need to make solid, financial decisions.

Brock Blake, “Why APR Alone Isn’t the Answer In Small Business Lending” Forbes, June 16 2016. Accessed via: http://www.forbes.com/sites/brockblake/2016/06/16/why-apr-alone-isnt-the-answer-in-small-business-lending/#6f7b97707f58