High interest rates drive businesses to risky tier-two lenders

Johannesburg - Many businesses are struggling in the high-interest-rate environment prevalent today, unable to secure traditional first-tier financing from cautious banks. As a result, they are increasingly turning to tier-two lenders that offer quick but costly loans. These lenders operate in a less regulated sector, where opaque terms of lending permit them to charge exorbitant interest rates that can significantly harm a business’s financial health.

“Fortunately, there is a more sustainable alternative available for businesses struggling with cash flow issues,” says Frank Knight, CEO of Debtsource. He suggests a better solution lies in invoice discounting, particularly when combined with credit insurance Debtsource has developed an invoice discounting solution which is relatively unique and new to the market.

Whatever bank marketing may claim, Knight says his experience with clients is that banks, while offering lower interest rates, are currently characterised by lengthy and cumbersome approval processes. “Businesses in urgent need of capital may find themselves waiting weeks or even months for a decision. In contrast, tier-two or unregulated lenders promise faster access to funds with minimal paperwork, appealing to businesses desperate for quick solutions.”

While these loans may be a lifeline for small businesses facing immediate financial challenges, a closer examination reveals that these loans can be financially devastating. For example, a tier-two lender might offer a loan of, say, R1 million with a repayment period of three to six months – but such loans typically range from 3-5% a month. Over a year, this translates to an annual percentage rate (APR) between 36% and 70%.

“These rates are calculated on a reducing balance, which makes it difficult for business owners to fully grasp the true cost of borrowing, as lenders do not always disclose the effective interest rate, leading to a lack of transparency,” says Knight.

“To understand the impact, let’s compare these tier-two rates to traditional credit costs. Typically, the cost of credit from conventional sources is calculated by adding the interest rate to the inflation rate and a margin for opportunity cost. For instance, with an interest rate of 11.75%, inflation at 5%, and an opportunity cost of around 2-3%, the total annual cost of traditional credit would be approximately 18%. In contrast, a tier-two loan with an effective annual percentage rate of 36% to 70% far surpasses the 18% benchmark, with elevated debt servicing costs meaning they cannot possibly turn a profit on products.”

The high-interest rates charged by tier-two lenders consequently can lead to a vicious cycle of debt. Businesses that resort to these loans may find themselves in a worse financial position than before.

Knight explains that the Debtsource Invoice Discounting Solution, developed in collaboration with Credit Circuit and Hollard Insurance, offers a more cost-effective and transparent option for businesses in need of immediate cash flow support.

It addresses many of the pitfalls associated with either tier-one or tier-two loans. “Firstly, there is no need for traditional security. Unlike traditional lenders, invoice discounting does not require businesses to pledge physical assets or personal guarantees. Instead, the security for the loan is provided by the data associated with the invoices. Secondly, businesses can access invoice discounting at prime interest rates, which are significantly lower than the rates charged by tier-two lenders. This is made possible because the invoice data is insured, reducing the risk for lenders.”

Businesses can receive up to 80-90% of the invoice value upfront, significantly improving cash flow. This means that businesses can quickly access funds without waiting for lengthy approval processes or high-interest rates. By using invoice data as security, businesses can retain their existing assets and security for other financial arrangements. This flexibility allows businesses to protect their core assets while benefiting from improved liquidity.

By exploring alternatives like those offered by the Debtsource/Hollard/Credit Circuit JV, businesses can manage their cash flow more effectively, protect their assets, and avoid the detrimental effects of high-cost borrowing. This approach not only ensures financial stability but also supports sustainable business growth in a challenging economic environment.

In addition to the prime interest rate, there is a separate cost for credit insurance, which is approximately 0.3% per month. Even with this additional cost, the overall expense remains substantially lower compared to second-tier financing options.

Given that turning to tier-two financiers is a sure route to financial disaster, it may appear questionable that companies ever take that option. Knight explains that many businesses go down this route when facing cash flow problems due to poor planning or delayed payments from clients. “This urgency can drive them to seek fast loans.

For businesses that need quick capital, this process can be impractical.”

In the current high-interest-rate environment, businesses must be cautious about their financing choices. While tier-two lenders offer quick access to funds, their high-interest rates and lack of transparency can lead to severe financial strain.