The subprime crisis illuminated just how dangerous it can be when loan brokers go unchecked. If we're not careful, we may have to learn that lesson all over again.
While new Dodd-Frank rules have reined in mortgage brokers, many of the brokers who cut their teeth in the run-up to the subprime crisis have reincarnated themselves in a new industry, this time targeting small businesses. Small-business loan brokers typically fall through the grips of regulators. Aside from fair lending laws, they aren't subject to federal oversight. Only a handful of states require brokers to obtain licenses. Highly regulated banks have traditionally steered clear of small-business loan brokers, but the explosive growth of largely unregulated online lenders has given them new opportunities to prey on unsuspecting borrowers.
Because finding creditworthy borrowers can be tough, brokers originate as much as three-quarters of all loans at some of the largest online lenders. That's worrisome news, since brokers' hefty commissions dramatically increase the costs of already-expensive loans. In one instance reported last year, a business borrowing $50,000 over six months would pay back $65,500, with the broker getting $8,500. The 17% fee is more than the lender would make on the loan, and about six times what brokers earn on typical Small Business Administration loans.
Worst of all, brokers rarely break out their fees to borrowers, so borrowers don't know how much they're paying for their brokers' services. These brokers also often market themselves as impartial when in fact many of them get expensive commissions from lenders and offer bonuses to salesmen for steering borrowers toward high-priced loans, even if cheaper options are available. As with the mortgage crisis, that avarice can ensnare borrowers in loans they can't afford and that aren't best suited to their needs.
Because the most egregious offenders are often offline loan brokers, some may think that the rise of online upstarts would bring greater transparency to the process. But make no mistake: while there's no question that the Internet has the potential to make finding a loan as seamless as booking a flight on Kayak, many of the most prominent online brokers engage in similar tricks, despite claiming to carry the torch of disruptive innovation.
These actions impugn the reputation of all brokers and undermine the positive role that brokers can play in facilitating loan discovery. After all, finding a business loan on your own can be daunting, consuming three full workdays on average and requiring that borrowers make sense of myriad complicated loan options.
Since brokers wield enormous influence over a borrower's financing decision, it's imperative to establish rules of the road that compel all brokers to respect the trust of borrowers. As a first step, lenders and brokers should agree to a broker code of ethics, keeping these principles in mind.
Above all, brokers should ensure that loan advice is in the borrower's best interest. That's a fair requirement, considering most brokers sell themselves as impartial advocates in the first place. Brokers should disclose conflicts of interest that could compromise the impartiality of their advice. Brokers could plainly notify borrowers if they will receive higher compensation for one loan over another, since these forms of self-dealing can incentivize them to push higher-margin loans even if they're not the best fit for a borrower.
Empower Borrowers to Make Informed Decisions
Brokers should educate borrowers on every loan option for which they qualify and endeavor to ensure borrowers understand consequences of financing decisions before they sign a loan document. Brokers could use tools like loan calculators and annual percentage rates to help borrowers comparison-shop across loan products. Brokers could also disclose the pros and cons of each loan product, especially regarding high-interest loans. Lending literacy is particularly important because many business owners are just as untrained in the nuances of loan options and terms as consumers.
Disclose All Fees and Terms
Brokers should clearly break out the fees they will add to borrowers' loans as part of the cost of doing business with them. The industry should also work on standardizing fee and term disclosure across brokers, so that borrowers fully understand what they're paying for. If a borrower can get the same loan more cheaply by going directly to a lender, they should be able to do so.
While a voluntary code of ethics is necessary, it's insufficient to rein in the most predatory brokers. Just as in the mortgage space, greater regulatory oversight is warranted. But that will take time. Until then, we should collectively support rules of the road to help borrowers distinguish between brokers who put borrowers' best interests first and those simply out for themselves.
Brayden McCarthy is head of policy and advocacy at Fundera, an online marketplace that connects small businesses with financing, and was previously senior economic policy adviser in the Obama White House and Small Business Administration. Follow him on Twitter @btmccarthy.