Nearly all of us have dreams bigger than our wallets. Whether it’s that bakery you’ve always wanted to open or that boat you can’t stop thinking about, few of us have the cash. For generations, banks have supplied the capital needed to turn these aspirations into reality.
Competition in the loans industry has ramped up in recent years. The internet has given fintech entrepreneurs a low-cost platform to launch third-party alternatives to the banks. Today, you can shop for secured and unsecured loans from vendors such as Prospa, as well as from high street financial institutions.
In this blog, we’ll brief you on the basics of secured and unsecured lending. Additionally, we’ll assess the state of the industry as it moves towards the 2020s.
Collateral: The Lubricant That Allows Secured Capital Flow
Prior to the 21st century, most borrowers acquired financing via the banks. However, they didn’t (and still don’t) part with their capital readily. Suffice to say, financial institutions aren’t in the business of losing money. To get a loan from a bank, you’ll need to offer up some collateral.
What is collateral? This term refers to any significant asset a bank can liquidate in case of a borrower default. If a loan goes bad, it enables them to recoup their losses. Common forms of collateral include real estate, vehicles, saving accounts, investments, and valuables like arts and jewelries.
However, do realize that banks lend 10-50% less of your collateral item’s value. As such, don’t expect to get a $250,000 business loan by offering a 2004 Ford Focus as security.
Getting Secured Bank Loans (even with Collateral) Is Getting Tougher
Times are tough for borrowers nationwide. Our long-lived property bubble has run out of steam. In some cities, like Sydney, it has burst. As a result, home equity is far less attractive as a form of collateral than it was several years ago.
This situation has slowed down secured lending to a crawl. Businesses that could count on financing from banks are suddenly struggling to even get an appointment with loan officers. This situation could become dire – not only is it impacting expansion plans, but emergency access to funds. Without the ability to cover bills or payroll when cash flow issues arise, some businesses could face failure.
What Are Unsecured Loans?
If this situation occurred 20-30 years ago, we would likely be facing a severe recession. However, thanks to private, non-bank lenders, capital-hungry businesses have been able to forge on with their plans.
Unlike banks, most of these operators offer unsecured loans to their customers. What are unsecured loans? Unlike secured credit, firms base approval and loan terms on the creditworthiness of an individual or entity.
While other factors do matter, a high credit score can secure sizable loans. With reasonable revenues and several years of existence, a business can borrow tens or even hundreds of thousands of dollars unsecured.
Even if a lender only extends loans to those with sterling credit, though, unsecured loans are far riskier than their secured counterparts. Even viable businesses can fall on hard times, due to unforeseen circumstances. Without collateral, the lender would be on the hook for the entire amount. Many companies have drum-tight margins – if even a few loans go wrong, it could collapse the firm.
To compensate, providers of unsecured loans charge higher interest rates than secured loan vendors. While not an attractive feature for borrowers, a decent credit history is the only thing many have to offer.
In some cases, a borrower with insufficient credit can secure capital with a qualified co-signer. In the event they default on the loan, the co-signer then assumes responsibility for the debt.
How Technology Is Helping ‘New-School’ Lenders Assess Risk
Offering capital on creditworthiness alone carries hidden opportunity costs. Factors other than credit score can make a borrower a suitable candidate. From time spent in business to cash flow, a lending business has multiple factors they can examine before releasing capital.
To that end, electronic application forms allow web-based firms to screen applicants, steering them towards lower-risk loans. Additionally, these lenders also ask for additional data to assess the fiscal health of borrowers. In business lending, information such as online sales and shipping data can paint a fuller picture of a company’s health.
Meanwhile, banks continue to rely on the same metrics they’ve evaluated for generations. Income, credit history, assets – these conservative markers of borrower integrity keep traditional financial institutions from losing too much. By being too careful, though, not only are they driving long-time customers to private lenders, but they are also missing out on opportunities for growth.
Are Unsecured Loans a Bubble That is Primed to Burst?
As institutions like the Commonwealth Bank of Australia have tightened lending standards, business owners have flocked to private lenders. Also called “shadow banks,” they have provided SMEs with badly-needed funding after a Royal Commission compelled conventional lenders to clean up their act.
Now, players like Prospa and Capify are among the only places left for bad credit business loans. However, just as the Australian real estate bubble appears to be deflating, could the same happen to private equity?
It very well could. Throughout much of the 2010s, Australian non-bank lenders were thriving. However, growth has exploded in the post-Royal Commission landscape. According to a Financial Times report, Athena Home Loans received more than 500 million AUD in loan applications during their first three weeks in business.
However, if the current housing correction spirals out of control, it could compromise the ability of borrowers to pay back their loans. As the home equity of Australians vanishes, their ability to spend will vanish with it.
This occurrence would impact retail sales, reducing the cash flow of businesses outside the real estate and finance industries. Many companies operate on thin margins – in a recession, some will start losing cash. If they are unable to right their ship, some will go bankrupt, throwing countless people out of work.
A wave of bankruptcies will impact the books of non-bank lenders. Improperly capitalized firms would likely fail. This chain reaction would amplify job losses, reduce spending capacity, and diminish the availability of credit nationwide.
For better or worse, unsecured lending is here to stay.
Despite the risks of non-bank lending, small businesses still require access to credit. After the Global Financial Crisis of 2008, lending standards tightened worldwide. Changes to bank lending enacted by the Royal Commission have made Australia’s borrowing environment even more challenging.
Non-traditional lenders are only filling a gap in the market. Imposing the same heavy-handed regulations on this segment of the financial sector would likely do more harm than good.