Personal Finance

The Middlemen That Can Drive Up the Cost of Your Loan

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As if alternative financing isn’t expensive enough, an illuminating article in Bloomberg Businessweek calls attention to the increasing use of intermediaries—brokers, in this instance—by small business and consumer borrowers seeking help finding a good deal on a loan.

There are two main types of financial market intermediaries: consultants and brokers. They couldn’t be more different in their approaches.

Consultants generally have no economic stake in an engagement’s outcome other than for the hourly or by-the-project rate they charge for their services. True, they may be in a position to recommend a lender or two along the way and, certainly, help to compare and contrast the proposals that ensue, but that’s as far as it goes.

Brokers, on the other hand, do indeed have a pecuniary card in the lending game. Their compensation can take the form of an upfront fee that’s typically expressed as a percentage of the loan value, or in an interest-rate premium that’s tacked on to the base rate their lender charges. (That spread may then be present-valued by the lender so that its present-day cash value can be paid upfront to the broker.)

Another Perspective on the Fees

Elements of the broker business model, however, should give pause to prospective clients.

To start, borrowers would be right to question rates and terms that are derived from an often limited universe of lenders. A little comparison-shopping can help with that.

Another cause for concern is when fronted fees are not conditioned on a borrower actually being approved for the loan. It’s hard to think of a good reason to pay in advance for a deal that may never close.

And then there’s also the matter of the fee itself.

Whether the cash is paid upfront or over time, brokers fees don’t just add to the transaction’s price tag (because they’re fully passed along to the borrower): they cause an already costly proposition to become even more so. The Bloomberg article, for example, describes an arrangement for which a 17% fee is added atop whatever is already being charged by the alternative lender for its six-month loan product. As terrible as a 17% surcharge may sound, it’s not nearly as awful as its annual percentage rate equivalent: roughly 70%.

(A back-of-the-envelope method for translating fees into APRs is to divide the former by the loan’s so-called half-life. In this case, a six-month loan that fully amortizes over the same period has a half-life of three months, or one-quarter of one year. Therefore, 17% divided by 25% equals 68%.)

The Bigger Picture

The lending operations I owned and ran were not favorably disposed to working with brokers. Apart from our concern about what we weren’t being told by an intermediary that had a financial interest to preserve, we were also sensitive to the amount of fee the broker was attempting to bundle into its deal—and not just because the borrower was footing the bill.

Brokers don’t take credit risk—the company that funds the loan does. The financial intermediary’s involvement ends the moment it cashes its check, while the lender’s persists until the final installment payment is made. So it’s hard to rationalize paying as much or more upfront than our company stood to earn over time.

That said, consider this: if a broker has the potential to earn, say, 17% of pure profit on the front end, and if the lender is loathe to pay as much or more than it has the potential to earn in due course, it’s safe to assume there is at least twice the amount (34%) of embedded profit in a deal of that type—$340 for every $1,000 borrowed for six short months.

If that doesn’t sound loud alarm bells in your head, perhaps it’s time for a checkup.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.

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