PYPL PayPal Holdings Inc

By Yuka Hayashi 

The growth of online lending has been a boon to hair salons, bakeries and other small businesses that don't qualify for bank credit. Yet this tech-enabled source of credit can mire some in debt they can't repay, raising concern about inadequate regulation.

Some are extending credit at sky-high rates with opaque terms for costly fees and conditions, drawing comparisons with payday lenders who target consumers in need of quick cash, according to critics.

"There is a significant number of bad actors who are mostly unregulated, " said Luz Urrutia, chief executive of Opportunity Fund, a California nonprofit that lends in lower-income communities. "They are really wreaking havoc across America's small businesses."

Nearly a third of the small businesses surveyed applied for online loans in 2018, up from 19% in 2018, according to a Federal Reserve study. The market's growth is driven by loans of less than $100,000, often as small as a few thousand dollars, according to experts.

The biggest players in online business lending include major names such as PayPal Holdings Inc., Amazon.com Inc. and Square Inc., which use data collected through their e-commerce or payments platforms to decide on offering small-business loans and at what terms. Lending to small and medium-size businesses by the top five digital platforms rose an estimated 39% in 2019 from the previous year to $13.5 billion, according to S&P Global Market Intelligence.

Most of the lenders don't make their fees public. An exception is On Deck Capital Inc., one of the few that is publicly traded, which charged annual rates ranging from 9% to 98.3% in the quarter ended September, with an average of 45%. By contrast, long-term bank loans guaranteed by the federal Small Business Administration currently are offered to borrowers, with fairly good credit histories, as low as 7%.

On Deck said it is "committed to providing fair and transparent financing options," noting that it had led an effort to create a standardized disclosure tool used by some large lenders.

But rates charged by smaller lenders can soar higher.

Opportunity Fund analyzed 150 online-loan contracts signed by 104 businesses in California before they came to the nonprofit lender in 2016. It found the average rate for such loans was 94% and the highest was 358%. Opportunity Fund charges 12% to 14% for its loans.

Online lenders pepper business such as auto-body shops and e-commerce stores with solicitations promising access to instant cash with no credit checks.

But beyond the high interest rates, the complex structure of some products and opaque disclosure make it difficult for borrowers to understand costs.

Johnathon Bush, the owner of Not Just Cookies bakery in Chicago, said he did a brisk business at farmers markets during the summer, but he faced a cash crunch in November 2018, just as he was gearing up for the holiday season.

After a bank rejected his loan application, he borrowed a total of $38,000 from two online lenders, which required him to pay back $56,000, including fees. The lenders immediately began withdrawing $450 from his bank account every day, eating up most of his average daily sales of about $600.

"I was able to eat and sleep, but there was nothing else left," said the 26-year-old Mr. Bush. "All the cash was going away fast." After defaulting on his loans in January he was able to borrow from family members, allowing him to keep his business.

He signed on to one of the murky products known as merchant cash advances, which technically are advances on revenues, not loans. Borrowers pay a fixed percentage of daily or weekly revenue rather than interest. The costs of such products are sometimes in the triple digits when converted into annual percentage rates for loans. Giving access to the borrower's bank accounts is a common practice in both payday lending and merchant cash advances.

In addition, many regulations to protect borrowers, such as requirements to disclose interest rates and bans on discrimination, apply to consumers, not businesses. Of the 30 million U.S. small businesses, 24 million have no employees besides the owners, according to the Small Business Administration.

"A vast majority of (borrowers) are consumers in every respect," said Glenn Christensen, associate professor of marketing at Brigham Young University. "Yet the law treats them as sophisticated, multimillion dollar companies."

Federal and state authorities are taking notice. California last year passed legislation that requires online lenders to disclose interest rates on small-business loans, just as they must for credit card and auto loans. The Federal Trade Commission in May said it planned to scrutinize unfair and deceptive practices in small-business lending.

In some states online lenders must obtain licenses and follow state interest-rate limits, sometimes set at 36% or lower, though some states have no limits. Many lenders partner with nationally chartered banks, which allow them to bypass state limits, a practice that has been challenged in court.

However, online lenders have filled a void left by banks that have limited small-business lending since the financial crisis because it was risky or unprofitable. While they are increasingly important sources of capital, online lenders' long-term prospects remain uncertain, according to experts.

Unlike banks, which fund their loans from stable pools of consumer deposits, online lenders mostly raise capital from hedge funds and other investors -- money that could evaporate in times of financial turbulence.

"The online lending industry is yet not old enough for two things," said Adrienne Harris, a University of Michigan professor and former Obama administration Treasury official. "One, to see how it performs in a downturn or a credit crunch. Two, nobody has really done the analytics to evaluate the trade off of increased access to credit with potentially increased cost."

Write to Yuka Hayashi at yuka.hayashi@wsj.com

(END) Dow Jones Newswires

December 30, 2019 14:41 ET (19:41 GMT)

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