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Why Small Businesses Are Turning to Online Lenders Online lenders are attractive because business owners know time, not money, is their most precious resource.

By Scott Shane

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Small business owners are increasingly turning to online lenders to fill their credit needs. One in five credit-seeking small businesses surveyed in 2013 applied to an online lender, a Federal Reserve Bank of New York survey reveals. And former Small Business Administration head Karen Mills (now a senior fellow at Harvard Business School) reports that online lending is the fastest-growing segment of the small-business-lending market.

The explosion in online lending to small companies has many financiers, regulators, pundits and policymakers wondering: Why are so small business owners turning to this funding source?

The answer is convenience.

Small business owners aren't turning to online lenders to save money. Loans from Internet-based sources of credit are generally pricier than credit from banks and other traditional brick-and-mortar lenders. The cost of the typical online loan, it turns out, is closer to the cost of the median credit-card loan than price of a typical term loan or line of credit from a bank. One study by economists at the Federal Reserve Board of Governors calculated that the average interest rate charged on an online loan is approximately twice that on a traditional bank loan.

Those running their own small companies aren't moving to online lenders because their odds of getting funding are better with them than with banks. While online lenders' loan-decision algorithms incorporate a wider range of information than most traditional small business creditors, allowing them to lend to borrowers with lesser credit scores, Internet-based lenders are actually less likely than banks to approve the loan applications submitted to them. A 2014 survey of small business owners conducted by the Federal Reserve Bank of New York found that online lenders had loan-approval rates of 39 percent, versus 59 percent for community banks and small regional banks, and 45 percent for large regional banks.

Related: How the Decline in Community Banks Hurts Small Business

Small business owners are turning to online lenders because the new creditors offer loan products that better fit their financing needs. These days, many small business owners do not need term loans to make major purchases, but instead require relatively small amounts of money to manage short-term cash-flow emergencies.

Online lenders are well positioned to meet this demand. Their loans tend to be smaller in magnitude and shorter in duration than traditional bank loans, a report by consultancy Oliver Wyman and Company found. Many online lenders also offer cash advances against accounts receivable, a type of financing that is especially helpful in smoothing out lumpy cash flow.

Small business owners also are attracted by the simple and rapid application processes at web-based lenders. In a survey of its customers, online lender OnDeck found that a significant number of its customers rejected the idea of borrowing from traditional credit sources because getting a loan from these lenders is "too difficult" and "takes too long."

Online lenders have accelerated and simplified the loan-application, decision, and funds-disbursal processes. Estimates show that applications at these creditors take as little as 1/50th the time to complete of those at traditional banks. Moreover, online lenders tend to accept or reject financing requests in hours, rather than the weeks it takes at banks.

Most small business owners believe that time, not money, is their most precious resource. They favor credit products that save them time, even if they cost more. Online lending is growing because many small business owners are willing pay higher interest rates to quickly and painlessly obtain loans that precisely match their funding needs.

Related: Replace the SBA's Outdated 7(a) Loan Program

Scott Shane

Professor at Case Western Reserve University

Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).

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