Reviewed on 18 February 2020
When you’re trying to get a loan to grow your business, is it better to borrow from a bank or a private lender? Here are some pros and cons of each to consider.
The answer is simply the one loan that you can get approved for.
But, every business owner wants a bank loan. In fact, many business owners think that their bank is the only place they can get a business loan. But, that is far from the truth.
Everyone wants a bank loan. Why? It is usually because bank interest rates can be lower.
Why do bank loans offer lower rates?
Banks typically have a lower cost of funds than other lenders. Depositors (their retail customers) keep a lot of money in their checking and savings accounts. Thus, banks have easy access to those funds to lend out. And, if banks don’t pay interest for those deposits or pay very little interest like they do today (most pay under ½ percent) – then those funds are very cheap for the bank to use.
Plus, all banks can access federal funds. And, right now the federal funds rate is (2.5%) – very cheap considering that in the past it has been around 4% or 6% and has been as high as 19%.
Private Financing on the other hand either have to get funds from investors who are looking for decent returns or from other banks and financial institutions who lend these private lenders funds at higher rates then it costs them to acquire that money.
Either of which raises private lender’s cost of funds which in turns gets passed on in their loan rates.
Let’s look at an example:
A bank needs to earn a spread on their loans of say 6% to cover the bank’s direct expenses and overhead costs (their cost of being in business).
If they can acquire funds at 2.5% then they can lend them out at 8.5% and still earn their spread.
A private financing company might need to earn a spread of 4% to cover its operating costs. But, its cost for the funds it lends out could be 7% or more to either repay the bank that lent them that money or to repay investors.
If the private lender’s cost of funds are 7% and its needs to earn a spread of 4% – it has to charge 11% at a minimum or go out of business.
Thus, it is easy to see why everyone wants a bank loan as opposed to a private lender loans.
But, banks are also opportunistic.
While banks can lend out funds at lower rates, they hardly do. Here’s why:
Banks see that their main competition (these private lenders) have to charge 11% or more – from our example. Thus, banks know that all they have to do is be below that figure to win your business. Thus, banks can charge 10% or 10.5% and still beat the competition.
Banks have other ways to make money. Thus, if you don’t want to pay their high rates, they really don’t care all that much. They can still earn a ton of revenue from banking fees or from taking those cheap funds and investing them to earn their 6% or more (investments in stocks and bonds or through acquisitions). Thus, they really don’t need to fund your business loan.
Banks have stiff regulations that pretty much forces them not to lend to new or small, growing businesses. These regulations are in place to protect their depositor’s money but also tie their hands when making loans (things like time in business, high credit scores, high cash flow requirements and low debt-to-income ratios).
Plus, banks add a lot of other costs to their loans – including fees, reporting requirements, covenants, etc. that are not included in their rates but make the overall cost of their loans higher.
Private Financing, alternatively, don’t have all those restrictions or alternative ways to generate revenue (beside fees which only happen when they close a loan). In fact, they are usually in business only to make loans.
Thus, private lenders tend to be easier to get approved by.
Kind of a double edged sword. Cheap money but hard to get on one hand and easy to get loans but higher rates on the other.
However, going back to the original questions, which is better? The answer still remains the loan that you can actually get; but it only remains true while you can’t get the other.
If you don’t qualify for a bank loan, make it your goal to grow your business to the point that you qualify for bank funding (you might not actually need it when you can qualify for it). But, in the mean time, if all you can get approved for is a private lender loan, then by all means; knowing that it is only temporary as your business grows.
Two things to remember here:
- The difference between 11% and 8.5% on a short-term loan (say under three years) is really not that much given the grand scheme of growing your business.
- Private loans are much better than not growing your business at all or losing your business altogether. As long as the use of those funds will return more than that loan costs – your business is really not losing anything.
Example: If you have an opportunity to earn $10,000 above the principal of the loan but can’t get a bank loan – do you just let the opportunity die or do you take the private loan and only realize say $9,000 in profits due to the higher interest rate?
You do what you have to do until you qualify for something better.
So, when seeking a business loan, which is better a bank loan or a private lender loan? It really all depends on what you can get approved for, be able to repay, and profit from.
Written by Melvin Ho, CEO & Founder of Bizsquare Management Consultants Pte Ltd, the one-stop business consultancy providing business, property, sme and working capital loans in Singapore. Bizsquare also provides invoice financing, mortgage broker, private financing and business overdraft.