The real cost of low doc loans for small businesses

Low doc business loans - i.e. the provision of loan cash without the need for standard documentary proof of income - are a popular choice among Australia's small businesses. This is unsurprising, as studies have repeatedly shown how difficult it can be for SMEs to achieve the funding they need, but it is also worrying, because low doc loans can be incredibly risky for the businesses they are meant to be serving.

The bottom line is that small businesses need funding - whether for expanding, purchasing stock or equipment, handling renovations, or for another purpose. The most common reason for SMEs seeking a loan, however, is to contribute to working capital - 35.28% of SME loans are for this purpose, according to findings published by Small Business Loans Australia - with debt consolidation (10.69%) lying in third place on the list. This demonstrates the precarious position that many small businesses find themselves in, and is a major red flag when it comes to assessing the risk of a low doc loan.

The Real Cost of a Low Doc Loan

Low doc loans are firm adherents to the old adage that if something looks too good to be true, it probably is. This is because, while low doc loans appear to be a relatively easy access point for the funding a small business really needs, the cost that the firms ends up paying over the lifetime of the loan period could be excessive, and even damaging to the business.

The bulk of the cost of a loan is made up of the following components;

• The ongoing fee, which is charged for the entire loan period
• The upfront fee, which is charged at the beginning of the loan period, or the point of establishment
• The interest rate, which is another ongoing charge which is based upon the balance of the loan at incremental points over its lifetime

As a low doc loan is considered to be of a higher risk to the lender, the lender will work to mitigate this risk through increased costs. These increases can be manifested across any of the components listed above. You can use a loan calculation tool like the one provided by Finder to independently verify the total cost of your low doc loan.

The Risks Low Doc Loans Could Pose to Your Business

So, a low doc loan is an initially attractive proposition that could end up costing a small business serious money in the long run, but what are the direct risks? Well, the most obvious risk is that ongoing costs and interest rates are so high, and charged over an almost indefinite period, that they end up crippling the small business which is meant to benefit from the loan.

This changes the complexion of the problem a little. Paying a large amount of money over a long time can be seen as wasteful and inefficient, but this is not usually considered fatal for a business. Now we are seeing situations in which increased rates are actually putting companies out of business altogether, as firms incur more debts in an attempt to manage the initial credit facility.

Much of this is due to difficulties in assessing future incomes and earnings for small businesses. These earnings can fluctuate across the financial year, and smaller organisations may be particularly susceptible to project shortfalls. By taking on a low doc loan, the business might be approved for the credit, but they are leaving themselves wide open to the potential risks.

Governments Taking Action

Any risk to Australian small businesses is a risk to the Australian economy as a whole, which relies heavily upon these smaller scale enterprises and the growth they achieve each year. As a result, it is no surprise that the government is seeking to take action against the seemingly cavalier attitude displayed by some lenders in the small business loans market.

The Financial Ombudsman Service Australia has published a document outlining its approach to low document loans, and to the disputes which arise from them. Rather than simply using low doc loans as a means of squeezing money from small businesses in the form of exorbitant rates, lenders are now required to apply a much more rigorous set of checks ahead of providing the loan, and may only provide credit facilities to those businesses who meet these criteria.

In the event that this does not take place, and a loan is provided to a company which cannot afford it, the business which acquired the loan has the legal recourse to raise a dispute via the ombudsman's office. The burden of proof now rests with the loan provider to show that they carried out the necessary checks.

These checks include ensuring that the company has held an ABN for at least one year prior to the applications, as well as credit checks and other assessments.

How Fintech is Providing a Solution

The trouble is, small businesses do not generally turn to low doc loans by choice. Instead, they explore this option because they lack the documentation required to acquire loans of other types. To put it simply, they have nowhere else to turn.

Or at least they didn't have. The financial technology, or fintech, revolution is beginning to provide real alternatives to these risky credit facilities, and streamlined application and decision processes are enticing increasing numbers of SMEs in this direction.

But it is not just ease of access which is turning small businesses towards the fintech option. Customised solutions provided to specific businesses, meeting their needs perfectly with a more personalised approach, have proved popular among businesses seeking the capital they need. In addition, fintech lenders are showing themselves to be more committed to transparency and responsibility than their more established counterparts, with Smart Company reporting that six Australian fintech lenders had put their signatures to a new code of practice for lending in the summer of 2018. A raft of other non-bank lenders such as Banjo Loans have been members of AFCA and signatories to the Banking and Finance Oath.

So, while low doc lenders are exposing businesses to unnecessary risks, the future does look bright, thanks to increased awareness regarding the dangers of a low doc loan, and the future-focused solutions offered by today's fintech service providers.