Making profitable SMB loans under $100,000 is nearly impossible when Oliver Wyman research indicates underwriting these loans costs a marginal $1600 – $3200, while they only generate $700 to $3500 in revenue on average. It doesn’t take a mathematician to figure out it hardly seems worth it to pursue small-dollar loans. However, larger banks have adopted technology that dramatically reduced the cost of consumer lending, so what’s stopping small business lending from heading in the same direction?
Small-dollar lending becomes profitable if you focus on three parts of the equation: reducing loan transaction costs; minimizing loan defaults and corresponding pressures on loan reserves; and improved, risk-based pricing.
1. Reduce Transaction Costs
Topline revenue potential for SMB loans is actually high, but the current cost structure is killing profitability. Clearly step one to profitability is reducing loan transaction costs. One quarter of small businesses that applied for additional credit during 2015 were denied. That’s a big cost that generated zero revenue. Online loan applications, by contrast, help banks return a “clear no” with minimal processing time and expense to the lender. Online applications also make paperwork-gathering and loan preparation considerably more efficient. Finally, the Mirador platform enables traditional lenders to route promising loans that fall outside their credit policy to a CDFI. These referrals may not drive fee income for banks, but can help save a customer relationship.
Early findings by Mirador client Excelsior Growth Fund support this theory in practice. In just nine months, EGF has reduced loan origination costs by 25-50%, thanks to a streamlined online loan application and more efficient loan analysis. Declined applications used to account for 30-40% of EGF loan officers’ time – now reduced to virtually zero. Read the case study to learn more.
2. Minimize Loan Defaults and Reserve Demands
In addition to lowering transaction costs, fintech has enabled lenders to reduce defaults and loan reserve demands. Cloud-based online loan platforms can also help with ongoing loan monitoring. Early warning system based on data helps banks intervene in loans possibly going south.
3. Introduce Risk-Based Pricing
Risk-based pricing is another innovation fintech enables that promotes topline revenue growth for lenders. Currently banks extend exactly the same price to all accepted loans; it’s a strictly binary model. By contrast, alternative lenders like Kabbage and Biz2Credit charge much higher prices to underwrite mostly edge-case loans. Traditional lenders could close this gap, with loan pricing that more accurately reflects the borrower’s risk profile. Newer lending models powered by fintech ground these risk decisions in data, not merely a hunch. Risk-based pricing is not only more affordable than alt-lenders for borrowers, it’s also more profitable for banks.
Potential growth areas for traditional lenders include younger SMB owners – whose demand for online lending and comfort with “high touch” digital financial services outpaces older business owners – and existing borrower relationships. The path to SMB lending profitability calls for reducing loan transaction costs, minimizing loan defaults, and considering more profitable, risk-based loan pricing.
Technology can enable numerous best practices that empower banks to achieve all these goals, with fast implementation, minimal internal workflow changes, and within their mature regulatory and security frameworks.
To learn more about how to use technology to lend profitably, download our recent whitepaper, Adapting the Best of Fintech to Small Business Lending.