Some of our partners recently reminded us how confusing small business lending can be. Largely it was based on the breadth of options given many fintechs filling the gap where traditional lenders have shown little appetite. There’s a solution for most things, but you have to know the basics to know where to start.
At the heart of it all, though often forgotten, is where the money actually comes from… Which in turn affects what you’re getting and how you get it.
Where the money comes from determines which of the two broad category of lending model it fits into; marketplace or balance sheet.
So let’s run you through the differences between a lending marketplace (the old P2P), and balance sheet lending.
What are they?
Balance sheet: Well, they hold the money they lend on their balance sheet. They have bought or borrowed it at a cost to then lend out to their customers. As it’s their money, the lender takes on all the risk.
Banks are the prime example of balance sheet lenders. Less well known is that many of the fintechs are also balance sheet lenders.
Marketplace: A service that enables investors (lenders) to lend money to borrowers directly. A marketplace provides the infrastructure required to facilitate the funding arrangement. Both parties generate value, with investors earning yield and borrowers getting the funding they require.
Marketplace lending in different forms covers all lending types and holds a fifth of the market share in regions such as the UK and US.
Where does the money come from?
Balance sheet: The money has generally gone through many hands, mainly via money markets and investment funds, with each clipping the ticket on the way through. This generally makes it a much higher cost of capital.
Marketplace: Investors fund their chosen portion of a loan directly and take ownership of their portion of that loan. This is commonly done via an online platform where investors can choose their risk-for-reward.
What does it cost?
There are two main costs a lender incurs that they then need to pass onto the borrower. The first is the cost of capital, or the cost of obtaining that money. The second is any margin they must charge to cover loan losses for which they are liable.
Balance sheet: They need to buy the money in advance, then need to charge to cover loan losses and operating costs. Prices range hugely.
The top end is frightening, with some rates close to 100% APR for an unsecured business loan.
Marketplace: They don’t have to buy the capital, and they also don’t have to price-for-risk to cover losses. The investors take the risk and return. This generally makes a marketplace better value and more transparent.
An equivalent loan may be as low as 10% APR and ending where some balance sheet lenders start.
What is the funding process?
Balance sheet: Once a loan application is approved, a balance sheet lender has the funds readily available to disburse.
Marketplace: A loan may be funded instantly, or may need to undergo a funding period as it is presented to investors (again via online platform).
Who takes the risk?
Balance sheet: The lender carries all risk for losses. They must price to account for those losses.
Marketplace: Investors take on that risk directly, when they invest in specific loans. Which is why investors generally diversify across many loans.