Fed Study on Marketplace Lending Reveals Need for Greater Consumer Education

Last week, the Federal Reserve Bank of Cleveland released a 24-page report on the public conceptions of alternative lending, from the perspective of small business owners. Authors Barbara J. Lipman and Ann Marie Wiersch conducted two separate online focus groups in November 2014 and March 2015, asking a total of 44 small business owners for their impressions of online marketplace lending, and gauging their understanding of common funding products offered by these companies.

The major takeaway is that many consumers don’t have a confident understanding of alternative lending products, and initially trust them less than traditional bank loans. On the other hand, those negative perceptions can be changed with a little bit of education.

In the most attention-grabbing section of the Cleveland Fed report, focus group members were presented with three different sample loan products, meant to reflect a merchant cash advance, an automated small business loan, and a bank loan, all based on $40,000 in funding and a repayment term of a year. (See chart below.) When asked to guess what the interest rate was for the MCA-esque first product, the small business owners gave a wide range of answers, suggesting a general misunderstanding of what’s actually being offered.

Cleveland Fed Funding Comparison

The study suffers from obvious flaws, however. For one thing, a merchant cash advance is not a loan; instead, it’s the sale of a portion of credit card revenue to a lender. Grouping it with the other loan products is misleading, especially when a specific term is attached to it. (“For purposes of comparing the three products, a one-year repayment schedule is presented.”)

With a merchant cash advance, a business owner pays a fixed percentage of credit card sales on a daily basis, and the length of time it takes to repay depends wholly upon the amount of sales that the business generates. With a small business loan, on the other hand, borrowers remit a fixed dollar amount, and the loan has a definitive maturity date.

This speaks to the larger problem of “comparisons” in alternative funding. Although many of the business owners who participated in the study said they wanted easier comparisons between available loan products across competing companies, marketplace lending products tend to be custom-built for each business, taking into account their revenue and overall financial health.

It takes more than just punching in a loan amount and repayment term to get a pricing quote for a funding product. (At Credibly, for example, a combination of data science and human analysis is used to calculate the pricing of each individual loan product.) Simple comparisons aren’t easy to come by when you’re comparing apples to oranges.

Still, the Cleveland Fed study did include some encouraging information. At first, the initial impressions of alternative lending from participants who hadn’t heard of online lenders or never used them before were generally unfavorable.

Consumers were concerned about high interest rates, poor customer service, and data security risks. But after the participants were asked to do some online “shopping” on marketplace lending websites, their impressions were often flipped to positive. Consumers were swayed by the simple application processes, the speed of accessing capital, the far greater funding access compared to banks, and the variety of products offered by marketplace lenders.

What the study really shows us is this: A lack of understanding about marketplace lending can create unfair misconceptions. For online lenders, educating customers should be a top priority, to ensure that business owners feel comfortable with the loan products being offered.

Considering how new marketplace lending is as an industry, it isn’t surprising that lenders have to work toward eliminating some negative stigmas. But as long as borrowers continue to have positive experiences that keep them coming back, it’s a challenge that the industry will surely overcome in time.

Download the entire Cleveland Fed study — “Alternative Lending Through the Eyes of ‘Mom & Pop’ Small-Business Owners” — right here.