Time for Online Lenders to Get Serious About Disclosure Boxes
Industry representatives swiftly rejected the Treasury Department's assertion that new legislation is needed to protect small-business owners.May 10
Lending Club and Funding Circle are among the firms pledging to adhere to a range of self-imposed standards in small-business lending.August 6
Many online small-business lenders worry that future regulations could stymie innovation in this fast-growing industry. But well-designed requirements would simply ensure that online lenders can offer adequate borrower protections without giving up market share.August 4
Since 2000, the so-called Schumer box has been to credit cards what nutrition labels are to food. Instead of listing calorie and carbohydrate counts, the summary table requires disclosure of basic numbers like the interest rate and annual fee at the top of credit card solicitations. Named for legislation by then-Rep. Chuck Schumer (now New York's senior Democratic senator), the box has a useful purpose, allowing a consumer who doesn't wish to pay high annual fees to easily toss aside expensive offers.
Yet when that same consumer applies for a small-business loan, he or she is left in the dark.
Credit extended for a business or commercial purpose is not covered by the disclosure requirements of the federal Truth in Lending Act; thus, lenders display loan terms and costs inconsistently. Some bury prepayment penalties deep inside 3-inch-thick loan documents. Few disclose an annual percentage rate, a number that would help loan prospects comparison shop.
A recent focus group study conducted by the Federal Reserve Bank of Cleveland was telling. The research found that mom-and-pop business owners are hard-pressed to compare credit products when using information provided on online alternative lenders' websites.
Such opacity is problematic. After all, how can borrowers get a fair shot at making informed financing decisions absent full and fair information about their loan options?
Lack of a model disclosure is all the more concerning amid rapid growth of nonbank online lenders. By 2020, Morgan Stanley estimates nonbank lenders will account for 20% of total small-business lending. These lenders are subject to less oversight on borrower protection than brick-and-mortar banks. In part because of this regulatory arbitrage, they are less likely to disclose basic terms and costs of loans in borrower-friendly ways.
To fix this, initiatives are underway to push for greater transparency in small-business lending. Regardless of which model the industry ultimately embraces, these five bedrock principles should guide the discussion on the disclosure boxes.
1. The disclosure box should be conspicuously presented in boldface type at the top of loan documentation so that borrowers don't have to waste time searching for the information. Small-business owners are generally time-strapped, particularly when they are searching for a loan. The average small-business owner spends 24 to 72 hours talking to lenders, filling out loan applications and submitting documentation, according to a survey conducted by seven Federal Reserve banks. Small-business owners deserve to see their terms without having to flip through pages of complicated documentation.
2. The box should capture all relevant information that borrowers should care about when making a loan decision. Indeed, in the Federal Reserve's same focus group highlighted above, virtually all participants said they want to see stated product features like duration, origination fees, financing charges expressed in dollar amounts and interest rates, as well as clear and conspicuous descriptions of late fees and prepayment penalties. Disclosure of monthly loan repayment terms would also be helpful given that small-business owners are more likely to think of their business cash flow on a monthly, rather than a daily, basis.
3. The disclosure box should empower borrowers to make straight-up and, where possible, side-by-side comparisons among loan options. While imperfect, universal disclosure of metrics such as an APR would help would-be borrowers understand their options. Sure, absent education about what an APR represents, the metric can be confusing to borrowers — especially for loans with durations of less than one year; however, an APR is ultimately something borrowers are familiar with when seeing the price of other financing products, like credit cards. It's also the only widely used metric for incorporating all origination fees and financing charges; therefore, it helps borrowers compare the true and total cost of credit products. To strike the right balance, model disclosures should show APRs, while also including straightforward language that highlights the pros and cons of this metric for particular products and terms.
4. The disclosure box should be written in plain English. Modern behavioral economics shows that there are distinct limits to people's ability to internalize complex financial products. In other words, lenders have an elevated responsibility to make sure language is truly understandable to borrowers. The purpose of a disclosure is — of course — to ensure that borrowers get a fair shot to understand the risks and rewards of any credit product before making their decisions.
5. The disclosure box shouldn't oversimplify or overcomplicate a loan's terms to the point of inaccuracy. Crafting a universal disclosure is difficult, particularly when considering the complicated nature of small-business loan products. Each loan comes with varying terms, repayment methods and use of proceeds. The challenge is to implement a disclosure box that balances the above considerations, many of which can be competing, while educating borrowers on the nitty-gritty of their credit offers.
Full transparency will not happen overnight; however, the industry aligning on a model disclosure is an important first step. Small-business lenders should start by applying the same principles that guided the creation of the Schumer box.
Brayden McCarthy is vice president of strategy at Fundera, an online marketplace that helps small-business owners compare credit options. He previously served as senior policy adviser at the White House National Economic Council and the U.S. Small Business Administration.