Do Interest-Free Loans Make Sense? No, but They Do Make a Difference

Conventional laws of business borrowing are typically as uncompromising as they are sacrosanct: Thou shalt most assuredly charge interest on any money lent.

However, thanks to two Pacific Northwest-based lending institutions, small-business owners like Kristi Wokoma are now able to disregard those rules while seeing their enterprises thrive.

“Starting a biz is challenging, especially when you don’t have start-up capital,” says Wokoma, owner of food manufacturer That Brown Girl Cooks, in Seattle.

Wokoma spent nearly two decades attempting to get her business off the ground. Initially she sold her food products at farmers’ markets and local independent grocery stores. However, neither allowed her to make a sufficient living without taking on additional jobs, like catering and cooking.

Like most entrepreneurs who find their growth stunted by precarious financial histories and meager credit scores, Wokoma stood at a crossroads, wondering how to expand her business. She had limited access to traditional small-business financing free of astronomical interest rates.

It was after visiting a Seattle library to hear a presentation on community financing given by Casey Dilloway, president of Seattle-based Community Sourced Capital (CSC), that Wokoma finally saw a viable opportunity. Dilloway spoke about business loans that were financed by members of the community, with principal-only payments. Wokoma, known by locals for her Black Eye Pea Hummus and other creations, was impressed.

After some time mulling it over, she plunged into the world of zero-percent finance. Last October, she received a no-interest loan of $12,500 from CSC and their lending partner, Craft 3, and has since expanded the distribution of her hummus into larger chain stores like PCC Natural Markets, the largest consumer-owned natural grocery co-op in the U.S.

Wokoma’s That Brown Girl Cooks fits the criteria for the type of business the financing partners have been targeting: It’s owned by a woman who is also a person of color, and located in an economically challenged area, Seattle’s District 2 (median income is less than $42,000).

While traditionally zero-percent interest has been scorned by the lending world, it’s a way of life for “social underwriting” firm CSC and community development financial institution Craft 3. The two recently partnered up to provide microfinancing loans between $5,000 and $50,000 primarily directed at businesses owned by women and people of color in low-income neighborhoods.

Craft 3 has been providing more conventional loans to underserved communities in Oregon and Washington state since 1994. They have built a reputation for enriching local communities by extending capital to community-based and ecologically sustainable businesses.

CSC’s model, on the other hand, concentrates on small investments, typically $50 to $150 from community members wanting to support local entrepreneurs, something that is often difficult for economically challenged communities to do, as they typically have less income to devote to such causes.

“We knew our model worked well for businesses that had a really established community around them … but we really didn’t see those people coming from low-income communities,” says Alex Mondau, CSC’s business development director.

“So rather than having a product that just doesn’t work for low-income communities, which is the status quo in the financial industry, it’s how can we do this better,” he continues.

Founded in 2012, CSC acts as a crowdfunding platform for small businesses that need modest amounts of cash to reach the next level of operations but may have been blocked from traditional channels of financing, like loans from banks or credit unions (both typically shy away from lending small amounts). While anyone can contribute, CSC primarily raises the capital from residents within a business’s surrounding area, allowing them to buy blocks of a loan, which they call squares.

The squares can be purchased in $50 increments capped at $1,000. The combined squares translate to the grand total a business owner is responsible for paying back, in monthly increments. While there is no interest attached, CSC does charge a $50 monthly service fee during the duration of a loan, which typically runs for 3 years. For a loan like Wokoma’s, this would equate to an interest rate of 9 percent – comparable to the industry average that can reach between 9 and 10 percent when administrative and other costs are taken into account – but higher amounts would have a lower effective cost (CSC and Craft 3’s borrower average is $25,400).

After months of discussion, CSC decided to partner with Craft 3 to offer a zero-percent interest loan where Craft 3 would match dollar-for-dollar any amount CSC raised. That $10,000 loan a business received from “squareholders,” as CSC refers to its loaners, now would be doubled to $20,000. All free of any interest.

A major benefit of the partnership for Craft 3 was that the vetting process normally involved with offering a business loan, which can be time-consuming and expensive, was outsourced to CSC. This freed up Craft 3’s resources to provide loans to more communities.

CSC and Craft 3 are loaning out amounts of money, expecting the exact amount back, no more no less (in addition to the monthly fee). All well and good, until you factor in that as time goes on the value of that money erodes. In 1965, $1,000 could buy you a lot more than it can today. You factor all that in and unfortunately and basically – outside of the few CSC charges – lenders are losing money on these loans.

If it sounds irrational, that’s the point, says Craft 3 CEO John Berdes.”Many, many normal people of modest means want to participate in a project/product that delivers intangible returns. People are irrational about what they’re passionate about, including community.”

Berdes says that local lenders agree to this bargain because their investments directly strengthen their communities – building businesses, increasing jobs, and fulfilling the dreams of their neighbors. This is especially true of communities of color, who are often denied the same level of access to financing as other communities; a recent survey of U.S. loan data revealed glaring disparities between the interest rate charged to minorities and other borrowers.

So far the partnership between CSC and Craft 3 has yielded more than $600,000 in financing for businesses in the region. Both Berdes and Mondau say the partnership is still in its embryonic stage, but they want to continue exploring how capital can help make the world a better place.

Here’s hoping mortgage lending isn’t far behind.