By Marc Prosser for Forbes
Over the last few years, the decline of bank lending and the rise of alternative online lenders has been at the forefront of the news. We hear a lot of talk about small businesses and consumers getting term loans, easily and quickly online. What we don’t hear a lot about are lines of credit, whether issued by banks or alternative lenders.
The reason? Lines of credit can be less profitable for lenders and investors. In this article, I explain some of the key differences between term loans and lines of credit and why the latter can be problematic for lenders and investors.
Lines of Credit: The Not So Cool Kid on the Block
Business lines of credit are so unpopular with lenders that many banks don’t even advertise them to small businesses or discuss them unless a customer specifically asks. Even when a bank does provide lines of credit, they usually come with stricter approval requirements than term loans, which can deter borrowers.
- Uncertainty as to whether, how, and when the borrower will use the line of credit.
- The bank can’t charge a lot of fees for something the borrower might not even use.
Lines of credit spell uncertainty for lenders. When a bank extends a line of credit to a borrower, there is no guarantee if all of the money or a portion of it is ever actually going to be used or when. Not only does that disrupt the bank’s ability to manage its balance sheet, but it also potentially loses future opportunities. The bank has to go through all the same underwriting steps that it takes to make a term loan, but it’s possible that it will receive minimal reward compared to a term loan.
For lenders and investors, the second main problem with lines of credit is related to the first. It’s hard to charge big fees when the line of credit is not being drawn upon (think about how credit cards work). Application fees and monthly maintenance fees associated with lines of credit are often small. With term loans, in contrast, the bank usually benefits from a big upfront origination fee plus pre-determined interest payments.
Credit Line Draws Increase When the Economy Slows
Although there is uncertainty about whether and when a particular borrower will use a line of credit, there are some general patterns in credit line usage that make them risky for lenders. Generally speaking, borrowers start drawing on their credit lines when the economy starts tightening and banks start pulling back on term loans. This is the worst possible time, from a bank’s perspective, for a borrower to utilize a line of credit.
The Federal Reserve tracked credit line draws by small businesses from 2002 through 2008 and found that “as banks grew more cautious about extending term loans, businesses opted to increase draw-downs on existing credit lines from banks.” In fact, since 2007, credit lines increased 7 percent.
(In the graph, C&I stands for “Commercial & Industrial”)
Two Federal Reserve analysts, Jose Berrospide and Ralph Meisenzahl, did another study last year that showed a similar trend. “Credit lines,” they found, “work as liquidity insurance that allows corporations to keep up with their investment plans during times of financial stress. This situation seems to be particularly relevant in an environment in which other funding sources… are not available.” When banks tighten access to term loans, it can scare small business owners, leading them to draw on existing credit lines so they will have a backup source of funds in case the economy tanks.
This doesn’t come as good news to lenders and investors. When the economy slows and lenders stop extending term loans, they want to see as much money as possible on their balance sheets. When borrowers get scared and start drawing on their credit lines, this money flows out and can leave lenders and investors scrambling.
It’s Not All Bad News
While lines of credit certainly present a myriad of issues, quite a few companies are trying to make a name for themselves in this space, especially on the business side of things. Examples include OnDeck, Dealstruck, BlueVine, and Kabbage, all of which provide small business lines of credit. No collateral is required; these areunsecured credit lines. By charging much higher interest rates than banks, these firms offset some of the risks associated with lines of credit.
However, even with interest rates much higher than a bank would charge, lines of credit may not be as profitable as term loans for alternative lenders and the investors backing them. The APRs on OnDeck term loans, for example, range from 8.9 % to 98.4 %, whereas the APRs on OnDeck lines of credit range from 13 % to 50 %.
Despite diminished profitability, alternative lenders offer lines of credit because they can reach a wider set of borrowers. Since their underwriting processes are largely automated, alternative lenders don’t have to worry about the work-to-reward ratio of a line of credit. Miranda Eifler, a spokesperson for OnDeck, says, “Over the course of the last 8 years, we’ve learned a lot about the financing needs of our customers, in particular that business owners need more than just better access to capital. They face a variety of financing needs throughout their lifecycles and need the right credit solution for each need – whether it’s buying seasonal inventory for a shorter-term ROI, expanding a location to maximize ROI long term, or managing cash flow on a day to day basis.” Lines of credit work better for short-term capital needs, and term loans are better for long term investments.
So far, alternative lenders have fared well, with default rates about the same as banks, but they got their start during the financial crisis. Only time will tell if, in a more normalized market, borrowers are able to pay back what they drew on credit lines and lenders and investors are able to make a nice return.
The article first appeared in Forbes