The ugly truth about online lending interest rates

What does an online business loan actually cost?

Funding options for small to medium-sized businesses have exploded in the last few years. Kabbage, OnDeck, BlueVine, Fundbox, Lending Club—the options seem endless, and most online lenders have similar, seductively simple qualification requirements:

  • 1–2 years in business
  • Personal credit score above 600
  • Minimum annual revenues of anywhere from $25K to $100K

The application process is simple and approval takes just a few days.

But this simplicity and speed come at a price—one that’s often very high and not particularly obvious.

To see how, we’ll look at some real-life examples. But first, let’s take a quick look at how loans are supposed to work.

 

How a loan is supposed to work

Let’s say you want to borrow $50,000 for six months.1 To understand how this would work with a bank, let’s look at an amortization schedule for this loan at a 6% interest rate (also called an APR or annual percentage rate):

Month Balance Principal Interest Payment APR
1 $50,000.00 $8,229.66 $250.00 $8,479.66 6.00%
2 $41,770.34 $8,270.81 $208.85 $8,479.66 6.00%
3 $33,499.53 $8,312.16 $167.50 $8,479.66 6.00%
4 $25,187.37 $8,353.72 $125.94 $8,479.66 6.00%
5 $16,833.65 $8,395.49 $84.17 $8,479.66 6.00%
6 $8,438.16 $8,437.47 $42.19 $8,479.66 6.00%

Notice that with a standard loan, the interest you are paying decreases each month.

This makes sense: interest is the price you pay for using someone else’s money, so as you pay off the loan principal, you should expect your interest payments to decrease.

In the above example, your APR is 6%. The total amount of interest you are paying is decreasing, however, because each month you pay off more of the loan principal.

This is how a loan is supposed to work—decreasing interest charges over time and a consistent APR that reflects the rate you signed up for.

 

How online lenders obscure true costs

One of the first things you’ll notice about most online lenders is that the cost of borrowing is not discussed in terms of annual percentage rate (APR), which is the standard measure in finance.

Instead, online lenders present a variety of different fees. Some of these companies have even invented their own terms with unique definitions.2

Why? Because if they actually talked about APR, it would be scary.

Let’s look at a couple examples.

 

Online Lender A—effective APRs of 50%+

Lender A’s pricing page explains that with their loans, you pay back a portion of the principal plus a fee each month. This monthly fee can range from 1.5% to 10% of the total loan amount.

For the sake of our example, let’s go with 5%. According to Lender A’s handy business loan calculator, your repayment schedule would look like this:

Month Principle Fee Total
1 $8,333.33 $2,500.00 $10,833.33
2 $8,333.33 $2,500.00 $10,833.33
3 $8,333.33 $500.00 $8,833.33
4 $8,333.33 $500.00 $8,833.33
5 $8,333.33 $500.00 $8,833.33
6 $8,333.33 $500.00 $8,833.33
Total $50,000.00 $7,000.00 $57,000.00

As you can see, Lender A has a unique fee structure: after the second month on a six-month loan, the monthly fee drops to 1% of the original principal.

So, what is the APR on this loan?

Calculating the APR here is tricky since you aren’t paying the same rate each month like you would with a normal loan.

We can get around this, however, by calculating the effective APR of the loan.  

To calculate your effective APR, take the average of your fees and interest over the given period of time, divide it by your average balance, and multiply it by 12.

This gives you the APR you would have had to pay each month from the beginning of the loan in order to have paid as much interest as you’ve been charged.

Month Balance Principal Fee Effective APR
1 $50,000.00 $8,333.33 $2,500.00 60%
2 $41,666.67 $8,333.33 $2,500.00 65%
3 $33,333.33 $8,333.33 $500.00 53%
4 $25,000.00 $8,333.33 $500.00 48%
5 $16,666.67 $8,333.33 $500.00 47%
6 $8,333.33 $8,333.33 $500.00 48%
Total $50,000.00 $7,000.00

In this example, your effective APR by the end of the six months is 48%. It’s even higher in the first few months, as high as 65%!

Recall that Lender A’s fees can range from 1.5% to 10%. What would happen if this loan was issued with a 10% monthly fee instead?

Month Balance Principal Fee Effective APR
1 $50,000.00 $8,333.33 $5,000.00 120%
2 $41,666.67 $8,333.33 $5,000.00 131%
3 $33,333.33 $8,333.33 $500.00 101%
4 $25,000.00 $8,333.33 $500.00 88%
5 $16,666.67 $8,333.33 $500.00 83%
6 $8,333.33 $8,333.33 $500.00 82%
Total $50,000.00 $12,000.00

We now have an effective APR of 82% by the end of the loan, and APRs has high as 131% in the second month.

But wait, there’s more: According to Chris A., former investor and board member of one online lender, 80% of online borrowers refinance part way through the loan.

Imagine if you refinanced this loan halfway through, at the end of month three. Lender A might come to you and say:

“Hi there, you’ve paid off $25,000 of your $50,000 loan. You’re doing great. In fact, if you want, we’ll give you another $25,000!”

Sounds goods, right? Chances are if you needed the original $50,000, you could use another $25,000.

But guess what? Refinancing means your payment schedule resets. Instead of month four, you’re now back in month one, paying $5,000 per month in interest and APRs over 100%.

It’s a vicious cycle.

 

Online Lender B—effective APRs of 100%+

Lender B is another online lender that provides both short and long-term loans. For comparison sake, let’s continue with the example above of borrowing $50,000 for six months.

According to Lender B’s pricing page, term loans have an average rate of 25.3% “Simple Interest,” defined by its website as the total amount of interest you pay as a percentage of your loan amount. In addition, for your first loan, there is an origination fee of 2.5%–4%. Finally, unlike Lender A, payments are made weekly.

For the sake of the example, let’s assume that we are paying the “average” Simple Interest of 25.3% and a 3% origination fee.

Since Lender B doesn’t provide a sample payment schedule, we’ll also assume that the principal and interest is divided equally among the 26 weekly payments.

What is the effective APR going to be?

Week Balance Principal Interest Origination fee Total cost Effective APR
1 $50,000.00 $1,923.08 $486.54 $2,000.00 $2,486.54 259%
2 $48,076.92 $1,923.08 $486.54 $0.00 $486.54 158%
3 $46,153.85 $1,923.08 $486.54 $0.00 $486.54 125%
4 $44,230.77 $1,923.08 $486.54 $0.00 $486.54 109%
5 $42,307.69 $1,923.08 $486.54 $0.00 $486.54 100%
6 $40,384.62 $1,923.08 $486.54 $0.00 $486.54 94%
7 $38,461.54 $1,923.08 $486.54 $0.00 $486.54 91%
8 $36,538.46 $1,923.08 $486.54 $0.00 $486.54 89%
9 $34,615.38 $1,923.08 $486.54 $0.00 $486.54 87%
10 $32,692.31 $1,923.08 $486.54 $0.00 $486.54 86%
11 $30,769.23 $1,923.08 $486.54 $0.00 $486.54 86%
12 $28,846.15 $1,923.08 $486.54 $0.00 $486.54 86%
13 $26,923.08 $1,923.08 $486.54 $0.00 $486.54 87%
14 $25,000.00 $1,923.08 $486.54 $0.00 $486.54 87%
15 $23,076.92 $1,923.08 $486.54 $0.00 $486.54 88%
16 $21,153.85 $1,923.08 $486.54 $0.00 $486.54 89%
17 $19,230.77 $1,923.08 $486.54 $0.00 $486.54 91%
18 $17,307.69 $1,923.08 $486.54 $0.00 $486.54 92%
19 $15,384.62 $1,923.08 $486.54 $0.00 $486.54 94%
20 $13,461.54 $1,923.08 $486.54 $0.00 $486.54 96%
21 $11,538.46 $1,923.08 $486.54 $0.00 $486.54 98%
22 $9,615.38 $1,923.08 $486.54 $0.00 $486.54 101%
23 $7,692.31 $1,923.08 $486.54 $0.00 $486.54 103%
24 $5,769.23 $1,923.08 $486.54 $0.00 $486.54 106%
25 $3,846.15 $1,923.08 $486.54 $0.00 $486.54 109%
26 $1,923.08 $1,923.08 $486.54 $0.00 $486.54 113%
Total $50,000.00 $12,650.00 $2,000.00 $14,650.00

With this loan, you will pay an effective APR of 113%.

No wonder online lenders don’t like talking about APR.

 

Bottom line: make online lending a last resort

Once you understand how online lending actually works, it’s not hard to see why companies avoid publishing real APRs anywhere on their site—instead discussing cost in terms of “simple” fee structures.

These fee structures may be simple, but they are far from transparent or cheap.

Funds may be easy to access, but that access comes at the price of predatory APRs that will have small businesses struggling to stay on top of payments instead of focused on running their company.

Instead of borrowing money to fund your business, why not have your own customers pay you early? We can help.

Interested in having your customers pay you early?

Search for a customer below to see if they offer an early payment program.

Search
Generic filters
Exact matches only
Filter by Custom Post Type

 


1 These numbers are used for simplicity. No bank would actually loan you $50,000 for six months—it just wouldn’t be worth it.
2 Here’s an example: One online lender coined the term “Simple Interest,” which it defines as “the interest you pay as a percentage of the total loan,” stripped of any relationship to time.